What Is Unearned Revenue, And Can It Hurt Your Business Finances?
While business owners are well-versed in the term revenue, many are unfamiliar with unearned revenue. Despite its name, prepaid revenue or unearned revenue isn’t technically revenue. However, it can offer a variety of benefits to your business.
Let’s dive deeper into what unearned revenue is, why it may benefit your company, and what you should do if you receive it from your customers.
Unearned Revenue Definition
Unearned revenue is money that your business has received for goods or services that it has yet to provide. You’ll eventually offer these goods or services, just not when your customers have paid for them.
While unearned revenue can come in many forms, the most common examples include prepaid insurance, service contracts, and subscription payments. Since more and more businesses are transitioning to subscription and membership models or pay-in-advance models, unearned revenue has increased in popularity.
If your business model requires that your customers pay you upfront, you’re accustomed to unearned revenue. After your customers pay you, they gain access to your goods or services. Unearned income is common for businesses such as:
Online Retailers
If you shop at an online retailer like Amazon, you pay for the product upfront. Until you receive the product in the mail, Amazon has collected unearned revenue from you.
Hospitality Companies
Hotels, resorts, airlines, and travel agencies will often ask you to pay for your booking in advance. For example, the hospitality company’s revenue is unearned until you take a flight or stay at a hotel.
Subscription Services
You may subscribe to a magazine, newspaper, meal delivery service, or subscription box and pay for it before receiving your subscription. The company will receive unearned revenue from you until they deliver all your purchased subscriptions. As they provide the prepaid service over time, they can record it as revenue on their income statement.
Prepaid Service Provider
If you sign up for a monthly cleaning or landscaping service and pay for a year’s worth of service, the provider will receive unearned revenue.
Unearned Revenue Example
Let’s say your business offers meal delivery services. A customer pays you $12,000 in January for annual subscription meals, and you deliver the first meal in January. At that point, only $1,000 of the customer’s payment is considered revenue, and the other $11,000 is unearned revenue.
Your unearned revenue will slowly decrease as the year goes by, and more cash flow will be available.
Is Unearned Revenue a Liability?
Unearned revenue is a liability because you’ve received the funds for a product or service you haven’t delivered. If you can’t provide your company’s offerings, you’d still owe the money to the customer. Therefore, you wouldn’t be able to record it as revenue. Once you do deliver, however, the liability will switch to revenue.
Unearned revenue is recognized as short-term liabilities on a company’s balance sheet. Unearned revenue will be listed as long-term liabilities if your products or services are delivered more than a year after your prepayment date.
For your customers, prepayments are assets. In most cases, they classify them as deposits or prepaid expenses. They don’t view the products or services you’ll eventually provide them as liabilities.
What Are The Benefits of Unearned Revenue?
Although unearned revenue is a liability because you haven’t technically earned it until you provide the good or service, it can still benefit you. Here are a few of the most significant advantages of unearned revenue.
Improves Cash Flow
Let’s be honest: cash is king when owning a successful small business. It’s what covers your expenses and helps you out during slow seasons. You’ll find it easier to keep a positive cash flow and stay afloat during challenging times by receiving payment upfront.
Increases Working Capital
If you’re a new business owner, you may depend on a bank loan to pay for your daily operations. If your customers pay you sooner, however, you may be able to increase working capital and avoid going this route. Remember, it’s better to be in debt to your clients who don’t charge interest than to a financial institution that will.
Satisfies Your Customers
Believe it or not, many customers prefer to make upfront payments. Doing so allows them to manage their cash flow and shows that they’re serious about your offerings. If you offer prepayment discounts, they may also save some money.
Conclusion: Be Sure to Deliver to Your Customers
Unearned revenue can help your business if you deliver your products or services as promised. Failure to do so can lead to lost customers, a poor reputation, and potential legal problems.
Editor’s Note: This post was updated for accuracy and comprehensiveness in April 2022