Unearned Revenue: What It Is and Why It Matters
Unearned revenue is money received by an individual or company for a service or product that has yet to be provided or delivered. It can be thought of as a “prepayment” for goods or services that a person or company is expected to supply to the purchaser at a later date. As a result of this prepayment, the seller has a liability equal to the revenue earned until the good or service is delivered. This liability is noted under current liabilities, as it is expected to be settled within a year.
Unearned revenue is also referred to as deferred revenue and advance payments.
Key Takeaways
- Unearned revenue is money received by an individual or company for a service or product that has yet to be provided or delivered.
- It is recorded on a company’s balance sheet as a liability because it represents a debt owed to the customer.
- Once the product or service is delivered, unearned revenue becomes revenue on the income statement.
- Receiving funds early is beneficial to a company, as it increases its cash flow that can be used for a variety of business functions.
Understand the Benefits and Challenges of Unearned Revenue
Unearned revenue is most common among companies selling subscription-based products or other services that require prepayments. Classic examples include rent payments made in advance, prepaid insurance, legal retainers, airline tickets, prepayment for newspaper subscriptions, and annual prepayment for the use of software.
Receiving money before a service is fulfilled can be beneficial. The early receipt of cash flow can be used for any number of activities, such as paying interest on debt and purchasing more inventory.
How to Record Unearned Revenue
Unearned revenue is recorded on a company’s balance sheet as a liability. It is treated as a liability because the revenue has still not been earned and represents products or services owed to a customer. As the prepaid service or product is gradually delivered over time, it is recognized as revenue on the income statement.
Here’s an example: If a publishing company accepts $1,200 for a one-year subscription, the amount is recorded as an increase in cash and an increase in unearned revenue. Both are balance sheet accounts, so the transaction does not immediately affect the income statement. If it is a monthly publication, as each periodical is delivered, the liability or unearned revenue is reduced by $100 ($1,200 divided by 12 months) while revenue is increased by the same amount.
Unearned revenue is usually disclosed as a current liability on a company’s balance sheet. This changes if advance payments are made for services or goods due to be provided 12 months or more after the payment date. In such cases, the unearned revenue will appear as a long-term liability on the balance sheet.
Reporting Requirements for Unearned Revenue
There are several criteria established by the U.S. Securities and Exchange Commission (SEC) that a public company must meet to recognize revenue. If these are not met, then revenue recognition is deferred.
According to the SEC, there must be collection probability or the ability to make a reasonable estimate of an amount for the allowance for doubtful accounts, completed delivery or ownership shifted to the buyer, persuasive evidence of an arrangement, and a determined price.
Example of Unearned Revenue in Action
Morningstar Inc. offers a line of products and services for the financial industry, including financial advisors and asset managers. Many of its products are sold through subscriptions. Under this arrangement, many subscribers pay upfront and receive the product over time. This creates a situation in which the amount is recorded as unearned revenue or, as Morningstar calls it, deferred revenue.
At the end of the second quarter of 2020, Morningstar had $287 million in unearned revenue, up from $250 million from the prior-year end. The company classifies the revenue as a short-term liability, meaning it expects the amount to be paid over one year for services to be provided over the same period.
Unearned revenue can provide clues into future revenue, although investors should note the balance change could be due to a change in the business. Morningstar increased quarterly and monthly invoices but is less reliant on upfront payments from annual invoices, meaning the balance has been growing more slowly than in the past.
Related Terms: liability, cash flow, income statement, balance sheet.
References
- U.S. Securities and Exchange Commission. “Topic 13: Revenue Recognition”.
