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How unearned revenue fuels growth

How unearned revenue fuels growth
Using advance payments for services or goods can be a great way to bolster cash flow during periods of growth. In this article, we’ll show you what unearned revenue is, how it should be properly accounted for, and how it can help your business grow.

You’ve decided to begin a new revenue stream for your mid-sized employee engagement company. Where before you would facilitate similar programming across your book of business, you now want to offer premium services to enterprise level clients. To sign on to the premium experience, clients may opt-in by paying $5,000 for events, perks, and quality assurance that will occur over the next 6 months. The influx of cash flow as clients opt-in is an exciting moment, especially for small businesses, but it’s important to take responsibility for how this transaction is recorded, applied, and what they represent.

What is unearned revenue?

The $5,000 payment you’ve received from your clients for the premium experience is considered unearned revenue. While you have been able to bring your clients in on a new premium experience, your business has yet to provide the services or products that have been promised in return for the opt-in. For this reason, the revenue is considered “unearned” and is recorded as a liability in the books.

Examples of Unearned Revenue

Unearned revenue can be an exciting and effective way to fund growth strategies while simultaneously testing the validity of those strategies. Customers that see the value in the advanced payment will pay. Let’s take a look at examples of “pre-payment.”

Example 1: Subscriptions and Prepaid Cards

If your business makes annual subscription payments for SaaS providers, has newspaper magazine subscriptions, or offers mass transit passes as an employee benefit, you are making advance payments. The seller that receives these payments is agreeing to provide, over time, a service that you’ve already paid for. They would record the full amount as a credit to unearned revenue and then credit the cash account each month incrementally. Making these payments guarantees the newspaper subscriber or bus rider access to these services while the funds provide the service provider and transit operator the means to maintain, grow, and develop those services.

Example 2: Cash Flow and Production Burden

Unearned revenue can also occur on a much larger scale than say a monthly bus pass. The $5,000 advance payments you’ve asked for from enterprise clients will result in premium services down the road. Those funds give your business the cash flow to hire and train new staff, design and launch a 24hr customer service app, and secure custom products from your supplier: each of these criteria is part of providing the premium service. It may even be that the advance payment your business receives is in turn paid to a vendor who requires a down payment for the increased production of components you already use. Your unearned revenue fuels growth across an array of other businesses. Without the prepaid funds, the new services would not be possible.

How to record unearned revenue

Recording unearned revenue can be a little tricky. In accrual accounting, the revenue is recorded as a liability and then credited or debited between accounts as necessary over time. Let’s take a look at the lifecycle of one $5,000 advanced payment.

Determine $5,000 as a liability

Unearned revenue is classified as a current liability on the balance sheet. It is a liability because it reflects money that has been received while services to earn that money have yet to be provided. If for some reason the company was not able to provide those services, the money may be forfeit.

Journal entries

The $5,000 has two entries: The first is a record of $5,000 debit to a cash account. The second is a $5,000 credit to unearned revenue. One way to remember how this works is to think of the income account as a lender to the unearned revenue account. The unearned revenue must eventually pay back the cash account as services are rendered.

Estimate amounts needed to perform specific service tasks

With prepayments in hand, your business can now budget where that money will go and for what reasons. After careful assessment you know that for each prepayment: $2,000 will go into hiring and training new staff, $2,000 to program a 24hr customer service app, and $1,000 is prepaid to your supplier to anticipate larger orders as the premium service launches.

Debit to unearned revenue, credits to cash

As each of the premium service elements are implemented, additional entries are made by the bookkeeper to indicate that services have been provided to the client. For example, once the new staff is hired and trained, a $2,000 debit entry to unearned revenue is entered and a $2,000 credit entry to cash is entered.

Add earned revenue to income

As the unearned revenue account is debited and the cash account is credited, the amounts change classification on the balance sheet. Where once the $5,000 was a liability, it is now a cash asset on the income statement.

Adhere to government reporting procedures

To comply with GAAP procedures—especially as a publicly traded company—revenue is recorded when work is actually performed. Another way of stating this is that both the income from a project and the expenses for the project must be recorded in the same time period according to regulations by the Security and Exchange Commission (SEC).

Unearned revenue FAQs

Is unearned revenue a contra account?

Unearned revenue is not a contra account. Contra accounts are used to record values that offset net revenue from actual revenue. For example, values of product discounts. If there is a sales revenue for $100 of a product sold and a $10 discount was applied to the product, a contra account for Sale Discounts would be used in the ledger to show the reason for the $10 difference in the net revenue of $90.

Is unearned revenue an equity account?

Unearned revenue is not an equity account. Equity accounts are those that represent ownership in the business in the form of various stocks or capital investments. Unearned revenue represents money received by the company for services that have yet to be performed.

Is unearned revenue accounts receivable?

Unearned revenue is not accounts receivable. Accounts receivable are considered assets to the company because they represent money owed and to be collected from clients. Unearned revenue is a liability because it represents work yet to be performed or products yet to be provided to the client.

Is unearned revenue a noncurrent liability?

Unearned revenue is actually a current liability, or a short-term liability. Noncurrent liabilities represent a long-term liability like loans, rent, or other lease obligations that last longer than a year. Unearned revenue indicates the intention to perform work for the advance payment within a closer time frame, typically within the next several months or less.

What is unearned revenue on a balance sheet?

Unearned revenue is always listed as a liability on a company’s balance sheet. On a summarized balance sheet, you probably won’t see it as a listed account, just included in the liabilities total. However, on a more detailed balance sheet, it would be listed as an account under liabilities either as current liability or even further detailed as unearned revenue.

What is the journal entry for unearned revenue?

Unearned revenue triggers two entries in double-entry bookkeeping. The first is as a debit to the cash account to represent that work has yet to be performed by the company to “earn” the advance payment. The second entry is as a credit to unearned revenue; the value of which is available funds for the work to be performed.

What's the difference between unearned revenue and deferred revenue?

Unearned revenue and deferred revenue are synonymous terms. They mean the same thing and can be used to refer to payments received for work or services yet to be performed or provided.

What's the difference between unearned revenue with accrual and cash accounting?

In cash accounting, unearned revenue is recorded as revenue when the money is received despite the fact that work is yet to be performed to “earn” the full payment. In accrual accounting, unearned revenue is considered a current liability and is not recorded as revenue until work has been performed. By recording in this way, adherence to the GAAP principle of periodicity is maintained, a requirement for public companies according to the SEC.

Conclusion

For businesses looking to expand services, advance payments are a great option to immediately increase cash flow. With compliant recording and follow through on client expectations, unearned revenue can make all the difference for securing growth standing out from competitors.

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