Why is Unearned Revenue a Liability?

According to the revenue recognition principle established under accrual accounting, a company is not allowed to recognize revenue on its income statement until the product or service is delivered to the customer. The important thing to remember is that until the products or services have been delivered to your customer, the money received should stay in the unearned revenue account, as it’s not yet recognizable as income. Deferred revenue is commonplace among subscription-based, recurring revenue businesses such as SaaS companies. When you receive money for a service or product you don’t fulfill at the point of purchase, you cannot count it as real revenue but deferred revenue. Since it represents products or services you owe your customers, you will record it as a liability.

Read on to learn about unearned revenue, handling these transactions in business accounting, and how ProfitWell Recognized from ProfitWell help simplify the process. Simply put, unearned revenue is money that has been received by a company but hasn’t been delivered. This can happen when customers pay for goods or services upfront but don’t receive them until later.

Why is deferred revenue classified as a liability?

In this case, the company has to hold onto the money until it can provide the product or service to the customer. In terms of accounting for unearned revenue, let’s say a contractor quotes a client $5,000 to remodel a bathroom. If the contractor received full payment for the work ahead of the job getting started, they would then record the unearned revenue as $5,000 under the credit category on the balance sheet. The contractor would also record the $5,000 in cash under the debit category. In accrual accounting, it is important to organize income properly, especially when it comes to prepaid services. Unearned revenue is a liability and is treated in a very unique way.

• As soon as the company provides all, or a portion, of the product or service, the value is then recognized as earned revenue.
• Let’s consider our previous example where Sierra Sports purchased $12,000 of soccer equipment in August.
• 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.
• Using advance payments for services or goods can be a great way to bolster cash flow during periods of growth.

Instead, you will record them on balance sheet accounts as liabilities (or assets for expenses) until you earn or use them. You will later move them in portions from your balance sheet accounts to revenues (or expenses) on your income statement. For example, a bakery company may need to take out a $100,000 loan to continue business operations. Terms of the loan require equal annual principal repayments of $10,000 for the next ten years. Even though the overall $100,000 note payable is considered long term, the $10,000 required repayment during the company’s operating cycle is considered current (short term). This means $10,000 would be classified as the current portion of a noncurrent note payable, and the remaining $90,000 would remain a noncurrent note payable.

Interested in automating the way you get paid? GoCardless can help

Over time, the revenue is recognized once the product/service is delivered (and the deferred revenue liability account declines as the revenue is recognized). Unearned revenue is most often a short-term liability, meaning that the business enters a delivery agreement with the customer or client and must fulfill its obligations within a year of purchase. Services that will take over a year to deliver upon should be marked as a long-term liability on the balance sheet. Unearned revenue is the cash received by a business from their product or services that yet to be provided. Unearned revenue can provide clues into future revenue, although investors should note the balance change could be due to a change in the business.

A company needs to manage its liabilities effectively to maintain financial stability and solvency. Securities and Exchange Commission (SEC) that a public company must meet to recognize revenue. The early receipt of cash flow can be used for any number of activities, such as paying interest on debt and purchasing more inventory. Because bookkeeping for startups the membership entitles Sam to 12 months of gym use, you decide to recognize $200 of the deferred revenue every month—$2,400 divided by 12. Here, we’ll go over what exactly deferred revenue is, why it’s a liability, and how you can record it on your books. This article explains what unearned revenue is for small business owners.

Other Current Liabilities

However, a business owner must ensure the timely delivery of products to its consumers to keep transactions steady and drive customer retention. This is why it is crucial to recognize unearned revenue as a liability, not as revenue. A business owner can utilize unearned revenue for accounting purposes to accurately reflect the financial health of the business. This type of revenue, for one, provides an opportunity to help small businesses with cash flow and working capital to keep operations running and produce goods or provide services. However, understanding how unearned revenue impacts the books and customer relationships is key to making the most out of this financial component.

Recognizing deferred revenue is common for software as a service (SaaS) and insurance companies. Unearned revenue is a liability since it refers to an amount the business owes customers—prepaid for undelivered products or services. In addition, it denotes an obligation to provide products or services within a specified period. Unearned revenue is a key metric for investors to watch, as it can provide valuable insight into a company’s potential future revenue.

The company classified it as a short-term liability — meaning that it expected to be paid over one year. Unearned revenues are short-term liabilities unless you deliver the service a year or more after receiving the payment. Once the service or product is delivered, the “debt” becomes revenue on the income statement.

From a SaaS accounting perspective, you will not earn that revenue until you deliver what you sold to the customer. It means that the $12,000 deferred revenue turns into revenue gradually with each month as the subscription progresses. For example, assume that each time a shoe store sells a $50 pair of shoes, it will charge the customer a sales tax of 8% of the sales price. The $4 sales tax is a current liability until distributed within the company’s operating period to the government authority collecting sales tax. Assume, for example, that for the current year $7,000 of interest will be accrued. In the current year the debtor will pay a total of $25,000—that is, $7,000 in interest and $18,000 for the current portion of the note payable.