What is Unearned Revenue?

Unearned revenue, or sometimes referred to as deferred revenue, is the

payment received by a company from its customers for products or services
that will be delivered at some point in the future. The term is used in accrual
accounting in which revenue is recognized only when the payment is received
by a company while the products or services are delivered to a
customer. Some examples of unearned revenues include advanced rent
payments, annual subscriptions for a software license, and prepaid insurance.
The recognition of unearned revenue is quite common for insurance
companies and software as a service (SaaS) companies.

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Accounting for Unearned Revenue
Accounting reporting principles state that unearned revenue is a liability of a
company. The rationale behind it is that despite the company receiving
payment from a customer, it still owes the delivery of a product or service. If a
company fails to deliver the promised product or service or a customer
cancels the order, the company will owe the money paid by the customer.
Therefore, unearned revenue must be recognized as a liability. Note that when
the delivery of goods or services is complete, the unearned revenue
recognized previously is recorded as revenue (i.e., the unearned revenue is
actually earned).
Unlike revenue, unearned revenue is recorded on the company’s balance sheet
under the liabilities section. Generally, unearned revenues are classified
as short-term liabilitiesbecause the obligations are typically fulfilled within a
period of less than a year. However, in some cases, when the delivery of the
goods or services may take more than a year, the respective unearned revenue
may be recognized as a long-term liability.

Example of Unearned Revenue

Fred is an avid user of Amazon.com’s services. Recently, he discovered
about Amazon Prime services. Fred wants to enjoy the benefits of the service,
such as free two-day shipping and access to unlimited music streaming and
buys the annual subscription for $79.
For Amazon, Fred’s payment ($79) is the unearned revenue since the company
receives the full payment in advance while none of the services have been
provided to Fred yet. Initially, the full amount will be recognized as unearned
revenue on Amazon’s balance sheet.
However, at the end of the first month, the monthly portion of the total
amount ($79/12=$6.58) will be deducted from the unearned revenue figure
and recorded as the company’s revenue. The similar procedure will be
repeated each subsequent month until the end of the 12th month when the
last portion of the payment will be recognized as revenue.

Unearned Revenue (Sales)

Unearned Revenue Definition
Unearned Revenue is a category of accrual under which the company
receives cash before it actually provides goods or renders services. Under this
cash, exchange happens before actual goods or service is delivered and as
such no revenue is recorded by the company. The company, however, is under
an obligation to provide the goods or render the service, as the case may be,
on due dates for which advance payment has been received by it and as such
the Unearned Revenue is a Liability till the time it doesn’t completely fulfill the
same and the amount gets reduced proportionally as the service is being
provided by the business. It is also known by the name of Unearned
Income, Deferred Revenue, and Deferred Income as well.

The most basic example of unearned revenue is that of a magazine

subscription. When we register for an annual subscription of our favorite
magazine, the revenue received by the company is unearned. As they deliver
magazines each month, the company keep on recognizing the corresponding
income in the income statement.
Unearned Revenue is a Liability on Balance Sheet
Normally, this unearned revenue on balance sheet is reported under current
liabilities, however, if the unearned is not expected to be realized as actual
revenue then it can be reported as a long-term liability.
As an example, we note that Salesforce.com reports unearned revenue as a
liability (current liabilities).

Unearned Revenues Example – Salesforce

Revenue in Salesforce consists of billing to customers for their subscription
services. Most of the subscription and support services are issued with annual
terms resulting in unearned sales revenue.

Unearned sales revenue is largest in the January quarter where most of the
large enterprise accounts buy their subscription services.
Unearned Revenue Accounting
When a company receives cash for the goods or services that it will provide in
future; it leads to an increase in Cash Balance of the company, since the goods
or service is to be provided in future, the Unearned Income is shown as a
Liability in the Unearned Revenue Balance Sheet of the company which
resulted in proportional increase on both sides of the Unearned Revenue
Balance Sheet (Asset and Liabilities). Let us now look at how Unearned
revenue accounting works.
Suppose company XYZ pays $12,000 for a maintenance and cleaning contract
to company MNC for a period of 12 months. How will MNC record this
unearned sales revenue on the Balance Sheet

Unearned Revenue on the Balance Sheet will look like

Now, after working for a month, MNC has earned $ 1000 i.e. it has provided its
services to XYZ, thus it will accrue its earning

Hence, $ 1000 of unearned income will be recognized as service revenue.

Service revenue will, in turn, affect the Profit and Loss account in
the Shareholders Equity section.

It is important to understand that while analyzing a company, Unearned Sales

Revenue should be taken into consideration as it is an indication of the growth
visibility of the business. Higher Unearned income highlights the strong order
inflow for the company and also results in good liquidity for the business as a
whole. Furthermore, unearned income doesn’t result in cash outflow in future
as only Unearned Sales Revenue, a liability, on the Unearned Sales Revenue
Balance Sheet, is reduced as revenue is recognized on providing the goods or
services proportionately.
Popular Industries where Deferred Revenue is common includes Airline
Industry(tickets booked by the customer in advance), Insurance Industry
(Insurance premium is always paid in advance), Legal Firms (Legal retainer paid
in advance), and Publishing Firms (subscription paid in advances) such as
Magazine etc. An airline Industry usually receives the advance payment of
tickets booked by customers but the actual service (travel date) usually
happen at a later date and such industries are required to report the same in
the Financial Statements as per the methods discussed henceforth.

Two Types of Unearned Sales Revenue Reporting

#1 – Liability Method
Under this method when Deferred Revenue is received by the business, a
liability account is created. The basic premise behind using the liability method
for reporting unearned sales revenue is that the amount is yet to be earned
and till that time the business should report the unearned sales revenue as a
liability. The common liability account used in the Deferred Revenue, Unearned
Revenue Balance Sheet etc. (Explained in detail with examples of unearned
revenue below)
#2 – Income Method
Under this method when unearned sales revenue is received by the business,
the whole amount received is recorded under an Income account and
proportionately adjusted as the goods or service is delivered by the business
over the period of time as goods or service is provided.

Unearned Revenue Journal Entries

Let’s understand the two types of unearned sales revenue reporting
through examples of Unearned Revenue Journal Entries:
ABC is in the business of publishing Business Magazine. The company receives
an Annual subscription of Rs 12000 from one of its clients on 31.03.2018 for
the next year. Revenue will be earned when the magazine will be delivered to
the client on a monthly basis. Unearned Revenue Balance Sheet as on
31.03.2018 will show an increase in Cash Balance by the amount of Annual
subscription of Rs 12000 and Unearned Income, a liability, will be created. The
said liability will decrease by the proportional amount of Rs 1000 on
30.04.2018 when ABC delivers the first installment of Business Magazine to its
client. Accordingly, ABC limited will deliver the remaining Business Magazine
to its client month on month and the same will result in Revenue Recognition.
At the end of the year on 31.03.2019, Deferred Revenue, a liability will cease to
exist and all revenue will be recognized in the Income Statement of ABC
Limited.
Journal Entry for Unearned Revenue under Liability Method

Journal Entry for Unearned Sales Revenue under Income Method

Unearned Sales Revenue results in cash exchange before revenue recognition

for the business. However, if a business does not follow the correct accrual
method of recognition of Deferred Revenue it can overstate the revenue and
resultant profitability without recognizing the corresponding expenses to
generate such revenue. Furthermore, that will also lead to a violation of the
Matching Principle of unearned sales revenue accounting which requires that
both expense and related income should be reported in the same period to
which it belongs.