What is Unearned Revenue?
Unearned revenue, sometimes referred to as deferred revenue, is payment received by a company from a customer for products or services that will be delivered at some point in the future. The term is used in accrual accounting, in which revenue is recognized only when the payment has been received by a company AND the products or services have been delivered to the customer. Some examples of unearned revenue include advance rent payments, annual subscriptions for a software license, and prepaid insurance. The recognition of deferred revenue is quite common for insurance companies and software as a service (SaaS) companies.
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Accounting for Unearned Revenue
Accounting reporting principles state that unearned revenue is a liability for a company that has received payment (thus creating a liability) but which has not yet completed work or delivered goods. The rationale behind this is that despite the company receiving payment from a customer, it still owes the delivery of a product or service. If the company fails to deliver the promised product or service or a customer cancels the order, the company will owe the money paid by the customer.
Therefore, the revenue must initially be recognized as a liability. Note that when the delivery of goods or services is complete, the revenue recognized previously as a liability is recorded as revenue (i.e., the unearned revenue is then earned).
Generally, unearned revenues are classified as short-term liabilities because the obligation is typically fulfilled within a period of less than a year. However, in some cases, when the delivery of the goods or services may take more than a year, the respective unearned revenue may be recognized as a long-term liability.
Example of Unearned Revenue
Fred is an avid user of Amazon.com’s services. Recently, he discovered Amazon Prime services. Fred wants to enjoy the benefits of the service, such as free two-day shipping and access to unlimited music streaming and buys the annual subscription for $79.
For Amazon, Fred’s payment ($79) is unearned revenue since the company receives the full payment in advance while none of the services have been provided to Fred yet. Initially, the full amount will be recognized as unearned revenue on Amazon’s balance sheet.
However, at the end of the first month, the monthly portion of the total amount ($79/12=$6.58) will be deducted from the unearned revenue figure and recorded as the revenue. A similar procedure will be repeated each subsequent month until the end of the 12th month when the last portion of the payment will be recognized as revenue.
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