Is unearned revenue a liability? In essence, yes, but a temporary one!
Аlso known as unearned income and deferred revenue, this form of advance payment refers to the prepayment received by service providers or sellers before they provide or ship out the paid-for service or product at a later date.
However, since the transaction still needs to be completed, the service and/or product provider takes on the same amount of liability as the revenue they receive, which will be eliminated once the goods and/or services are delivered.
Keep on reading as we explore the topic in depth below!
What Is Unearned Revenue?
Deferred income is the amount of advance payment consumers provide to companies offering services and products with pending deliveries or provisions.
Common examples of unearned revenue include prepaid insurance policies, legal retainers, transportation tickets, magazine subscriptions, car pre-orders, etc.
However, until the service is provided, the business is essentially in debt to the customer, which is why such income is recorded as a liability.
Which Industries Have Mostly Unearned Income?
Many modern industries take payments in advance from customers, using this cash flow for any number of purposes and activities, including preparing the goods or services to be delivered, covering their loan interests, paying their operational costs, etc.
Some of the most common examples include and are not limited to the following:
- Air transportation—to travel via plane, customers must first purchase a ticket, which reserves them a seat at a time and date;
- Streaming industries—every streaming industry, including music, film, and tv, requires you to pay upfront for the content it will deliver to your device;
- Property renting—for some types of properties, landlords require an upfront payment for a specific time period;
- Automotive industry—custom-made luxury vehicles are paid for upfront due to their high production costs;
- Fashion industry—similar to how exclusive cars are ordered and made, haute couture items are also ordered on demand;
- Gaming industry—every modern game goes through a pre-order phase, during which gamers can pre-purchase the title and get extra in-game items;
- Software companies—software companies are operating on a SaaS model nowadays, i.e., the customer pays to use a license for a specific period;
- Live concerts and experiences—to participate in certain happenings, customers are required to purchase tickets to enter the venue;
- Consultation services—when hiring a business, legal, accounting, or another type of consultant, clients typically pay a retainer fee;
- Prepaid phone and TV services—most telecommunication companies offer prepaid plans for a month, quarter, or even a year;
- Crowdfunded startups—since some entrepreneurs and innovators lack the capital needed to start a company or fund a project, they raise money from the public with the promise of product delivery at a later date.
Operating with unearned income is typically preferred by small businesses as they most often have to cover the production cost of the ordered item.
Also, they often customize the order, so receiving a prepayment allows them to buy the exact raw materials they need. However, the biggest benefit is the revenue forecast they get, as they can easily calculate their future revenue based on their orders.
Why Is Unearned Revenue a Liability?
From an accounting point of view, advance payments must always be entered as liabilities in order to keep the ledgers balanced. If you were to enter such revenue as an asset, the profits would be overstated for the specific accounting period.
Therefore, to avoid violating the accounting equation—Assets = Liabilities + Equity—payments for undelivered products and services become liabilities. After all, businesses that fail to provide the service are indebted to the customer and have to repay them. Furthermore, the customer has the right to cancel the contract in most cases.
How Is Unearned Income Recorded?
Once a company receives payment for services or goods to be provided, it enters it into its deferred income account as a liability. However, some companies also keep a cash flow statement that records such payments as they are used for daily operations.
Any and all revenue entries previously recognized as liabilities will be re-recorded as actual revenue when the actual delivery of goods and/or services happens. Namely, the company truly earns said revenue after the transaction is closed.
For instance, a company that sold Christmas gifts ahead of time, which are to be delivered in December, will not record the sale on September’s, October’s, or November’s monthly income statement, but rather in December once the sale is concluded.
However, in the case of a subscription service paid in total but provided on a staggered monthly basis, companies will gradually reduce their unearned revenue sheet while increasing their actual revenue by the same amount each month.
Note: In most cases, unearned revenues are short-term liabilities since businesses fulfill their obligations within a year of receiving payment.
- Unearned income is an advance payment made by customers for services and/or products to be delivered in the future.
- Such income is recorded as a liability since the company will be indebted to the customer until it provides the paid-for items.
- If the delivery does not occur for whatever reason, the contract is voided, and the business has to refund the customer fully.
- Once the transaction is completed, accountants transfer the amount from the deferred income category to the revenue one.