How to Understand Unearned Revenue
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 be beneficial to 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 provide these goods or services at a later time, just not when your customers have paid for them.
While unearned revenue can come in many forms, the most common examples of it 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. Only after your customers pay you, do they gain access to your goods or services. Unearned revenue is widely seen in businesses such as:
If you shop at an online retailer like Amazon, you pay for the product upfront. Until you actually receive the product in the mail, Amazon has collected unearned revenue from you.
Hotels, resorts, airlines, and travel agencies will often ask you to pay for your booking in advance. Until you take the flight or stay at the hotel, for example, the hospitality company’s revenue is unearned.
You may subscribe to a magazine, newspaper, meal delivery service, or subscription box and pay for it before you receive your subscription. The company will receive unearned revenue from you until they deliver all the subscriptions you paid for.
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 subscription meals for the entire year, 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.
As the year goes by and you deliver more meals, your unearned revenue will slowly decrease and you’ll have more revenue on hand.
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. In the event that you aren’t able to deliver your 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 recorded under short-term liabilities on a company’s balance sheet. If your products or services will be delivered more than a year after your prepayment date, unearned revenue will be found under long-term liabilities.
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?
Even though unearned revenue is considered 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 noteworthy advantages of unearned revenue.
Improves Cash Flow
Let’s be honest; when it comes to owning a successful small business, cash is king. It’s what covers your expenses and helps you out during slow seasons. By collecting upfront payment, you’ll find it easier to keep a positive cash flow and stay afloat during hard times.
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 a financial institution who will.
Satisfies Your Customers
Believe it or not, many customers prefer to make upfront payments. Doing so allows them to manage their own 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. However, this only holds true if you deliver on your promises and follow through with your products or services. Failure to do so can lead to lost customers, a poor reputation, and potential legal problems.
Editorial Note: Any opinions, analyses, reviews or recommendations expressed in this article are those of the author's alone, and have not been reviewed, approved, or otherwise endorsed by any of these entities.