Being aware of your company’s financial techniques will help you have a better knowledge of its financial requirements. For this reason, we have put down all you need to know about Unearned revenue.
This is especially useful if your company runs into financial difficulties that necessitate a thorough understanding of how to deal with them.
Furthermore, as a business owner, unearned revenue is helpful to cash flow and advanced payments, retainers, and deposits are all different ways to collect a very important liability on your books
Read on to find out what exactly unearned revenue is, how it works, benefits, etc.
What Is Unearned Revenue?
Unearned revenue or income, which is also known as deferred revenue, is money received by a corporation from a customer for products or services that will be given at a later date.
The term comes from accrual accounting, which recognizes revenue only when a corporation receives cash AND the products or services have not yet been delivered to the consumer.
Examples of Unearned Revenue Includes
Some examples of unearned revenue Includes:
- Service contract paid in advance
- Legal retainer paid in advance
- Advance rent payment
- Prepaid insurance
- Annual subscriptions for a software license.
For example, a client pre-pays for a dog walking package. The plan includes three months of walking. The cost is $1200 per month at $400 per month. The client makes a one-time payment of $1200. The firm owner deducts $1200 from cash and credits $1200 from unearned earnings.
The business owner then decides to keep track of the accrued revenue on a monthly basis. Earned revenue is recorded in an accrual, which is a type of adjusting journal entry.
The owner deducts $400 in unearned income and credits $400 in revenue at the end of the month.
He continues to do so until the three months are up and he has accounted for the entire $1200 is generated and collected revenue.
Importance Of Unearned Revenue
According to Accounting Tools, Unearned revenue is beneficial to a small business’s cash flow since it provides the funds needed to pay for any future project expenditure.
How Does Unearned Revenue Works?
Here is how unearned revenue works.
On the balance sheet of a company that gets an advance payment, unearned revenue is recorded as a liability. This is because it owes a customer responsibility in the form of products or services.
Also, because there is still a chance that the good or service will not be provided, or that the buyer will cancel the transaction, the money is considered a liability to the company.
Unless alternate payment terms were clearly indicated in a signed contract, the company would be required to compensate the customer in either situation.
Contracts can have many stipulations, such as the possibility of no income being recorded until all services or products have been supplied.
In other words, the payments received from the customer would be classified as unearned revenue until the client received the whole amount due under the contract.
Since prepayment terms are usually for 12 months or less, deferred revenue is usually represented as a current obligation on a company’s balance sheet.
However, if a customer made an up-front prepayment for services that will be delivered over several years, the portion of the payment that relates to services or products that will be delivered after 12 months from the payment date should be classified as unearned revenue under the long-term liability section of the balance sheet.
Accounting For Unearned Revenue
As a corporation earns the revenue, the balance in the unearned revenue account is reduced (with a debit) and the balance in the revenue account is increased (with a credit).
On the balance sheet, the unearned revenue account is normally categorized as a current liability.
If a company does not deal with unearned revenue in this way and instead recognizes it all at once, sales and profits will be overestimated at first, and later underestimated for the periods in which the revenues and profits should have been recognized.
Revenues are recognized immediately, but associated expenditures are not recognized until subsequent periods, which is a violation of the matching principle.
Benefits Of Unearned Revenue
Here are the benefits of unearned revenue for small business owners.
#1. Gets money in your pocket, sooner
Money reigns supreme. It is necessary for your survival. It’s what keeps you afloat during dry spells and pays the bills.
However, you can’t always rely on your customers to pay you on time. According to research by the Freelancer’s Union, 71% of freelancers experience difficulty getting paid at some time throughout their careers.
Not being paid can have a significant impact on your cash flow, especially if a late payment causes you to spend more than you make in a month.
So, what’s your best counter-argument? Before launching a new project, collect revenue in advance. You may keep your cash flow positive by charging a deposit up ahead, allowing you to stay afloat.
#2. Increase your working capital
The perfect project has just arrived in your inbox, which is every small business owner’s dream. It’s just what you’re looking for to complete your portfolio!
But there’s a snag…
It necessitates a significant amount of upfront funding, which you lack.
This is when working capital enters the picture. You must be able to handle day-to-day operations as well as payroll costs. But where can you get the money you need to meet your capital needs?
Generally, you could borrow money from a bank. Alternatively, you might just persuade your customers to pay you sooner, either in installments or as a deposit.
After all, it’s better to be in debt to your clients rather than the bank if you’re going to be in debt. At the very least, your customers do not charge you interest.
#3. Lets your clients break up payments
Your clients must also consider their own financial flow. Breaking down their project payments into smaller chunks can be really beneficial.
You may, for example, offer your customers the option of paying for the entire year in advance and receiving a discount. Allow your client to pay for a larger project partially upfront or in installments at important milestones when the time comes.
Payment options are a guaranteed method to keep clients motivated and involved in the job being done, in addition to being handy for your clients’ financial flow. After all, the project has already been paid for!
What Is Unearned Revenue on a Balance Sheet?
Unearned income is recorded on a company’s balance sheet, which is a crucial financial statement that is commonly prepared using accounting software.
An example of a balance sheet is shown below. This balance sheet does not include unearned revenue as a line item. Because it involves money owed, it would fall under the “liabilities” category.
The company has yet to provide the service or provide the products that were paid for.
This is an example of a well-detailed balance sheet. Unearned revenue is listed under “current liabilities.” It is part of the total current liabilities as well as total liabilities.
Furthermore, assets must always equal equity plus liabilities on a balance sheet. Both sides of the equation need to be in sync.
This is why unearned revenue is documented as a balance of unearned revenue (a liability account) and revenue (a revenue account) (an asset account). This ensures that the equation remains balanced.
What Is The Difference Between Unearned Revenue vs. Deferred Revenue
The quick answer is that both phrases signify the same thing: a company has been compensated for goods or services it has yet to provide.
Here’s a more detailed explanation of deferred and unearned revenue, along with some examples to help you understand it.
Both deferred and unearned revenue are accounting phrases representing money received by a corporation for goods or services that have yet to be delivered.
In other words, before deferred revenue can be deemed an asset, the corporation must take some action. If the corporation is unable to produce the goods or services as promised for whatever reason, the deferred income must be returned.
It’s also worth noting that deferred revenue can be utilized to cover the costs of finishing the job.
In conclusion, Deferred or unearned revenue is an important accounting term that aids in the accurate reporting of assets and liabilities on a balance sheet.
Also, it makes it crystal evident to shareholders and other stakeholders that the company still owes money and that not all of its revenue can be considered assets.
Prepaid revenue is the accounting term for unearned revenue. This is money paid in advance to a company before it supplies goods or services to a customer.
Furthermore, unearned income is a liability, which is money owed to a corporation. An adjustment entry is made when the goods or services are delivered. Cash flow is aided by unearned revenue.