Is unearned revenue an asset? If you are not familiar with the various accounting principles that businesses use, you will be wondering what unearned revenue means and whether it is an asset; these we shall discuss hereafter. When individuals or corporate entities want to purchase a product or service, three options are available to them. They can make an upfront payment before receiving the product or service, pay in cash when the product is delivered or the service is rendered, or purchase the product or service on credit in which case they might receive a sales discount. When an upfront payment is made for a good or service, this income is considered unearned revenue.
Unearned revenue consists of all payments made by a company’s clients in advance for products or services that will be received in the future. This revenue is usually not recorded on a company’s income statement until it has been earned. When the product or service has been delivered to the client, the revenue is then recorded on the company’s income statement as either sales revenue or service revenue. This depends on whether the revenue was earned from selling a product or providing a service. Revenue earned from the sale of a product is recorded as sales revenue and that earned from a service rendered is considered service revenue.
Let us have an understanding of unearned revenue and assets so that we can ascertain if unearned revenue is an asset or not.
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Understanding unearned revenue and assets
In order to ascertain if unearned revenue is an asset or not, we will need to have an understanding of what unearned revenue is. We additionally need to understand what assets mean. These we shall discuss below.
What is unearned revenue?
Unearned revenue is the prepayment a company gets from customers for goods or services. The customer makes the prepayment in expectation of being delivered the good or service.
Unearned revenue can be a potential source of great economic gain for the company, this is because it can be used to reinvest in the business, pay off debt or take care of some other operational obligations. Businesses can additionally utilize the increased cash flow accruing from unearned revenue to provide services and produce goods. Unearned revenue is also utilized for accounting purposes to accurately reflect the company’s financial health. Hence understanding whether unearned revenue is an asset is important.
The Securities and Exchange Commission (SEC) holds that unearned revenue should not be recognized until it is realized or realizable and earned. For revenues to be considered earned, the company to whom the prepayment was made has to accomplish what it must do to be entitled to the revenue. This means that the product or service has to be delivered to the customer before the prepayment for it is considered earned. The SEC additionally outlines the following as criteria for recognizing that income has been realized in its revenue recognition bulletin.
- Persuasive evidence of an arrangement exists
- Delivery has occurred or services have been rendered
- The seller’s price to the buyer is fixed or determinable
- Collectibility is reasonably assured
When these conditions are met, the unearned revenue can then be recorded on the income statement of the company as revenue.
Both startups and established companies can have unearned revenue provided they accept upfront payment for the goods or services they offer. Unearned revenue can also be beneficial to them since it adds to the available funds for daily business operations.
Unearned revenue is also referred to as deferred revenue, advance payment, or prepaid revenue.
Types of unearned revenue
- Current unearned revenue
- Non-current unearned revenue
The aforementioned are the two types of unearned revenue that a company can realize. The customer agreement signed before the unearned revenue payment by a customer may give the customer the right to cancel their purchase or receive a refund in case of certain events that are included in the contract terms.
Current unearned revenue
When a customer makes a prepayment for goods or services that have to be delivered within one year, the unearned revenue accrued from such prepayment is considered current unearned revenue. For instance, if a customer makes a prepayment to a clothing company and the clothes that have been paid for will get delivered to the customer within a year, then, this revenue will be classified as current unearned revenue.
Non-current unearned revenue
When a customer makes a prepayment for goods or services that have to be delivered in more than one year, the unearned revenue accrued from such prepayment is considered non-current unearned revenue. For example, assuming Henry paid for a three years subscription to a magazine producer, his prepayment for the first year will be recorded as a current unearned revenue while the balance for the subsequent two years will be non-current unearned revenue since their delivery will be in more than one year.
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What are assets?
Assets are tangible or intangible resources that can be utilized to drive economic value. These resources can be owned by individuals, corporate organizations, or the government. Tangible assets refer to those resources that can be seen physically such as equipment, cash, plant, property, etc. Nontangible assets are resources that cannot be seen in themselves such as intellectual property, patents, trademarks, etc.
Assets are generally classified as current or non-current. The current assets comprising of those resources that can be converted to cash within a year such as cash, short-term investments, prepaid liabilities, and accounts receivable. Non-current assets require longer than a year to be converted to cash such as property and all fixed assets.
Corporate organizations keep a record of their assets, liabilities, and equity on the balance sheet based on the accounting equation which recognizes that assets are equal to the sum of liabilities and equity of a company. Assets are usually recorded on the credit side of the balance sheet while liabilities and equity are recorded on the debit side.
Is unearned revenue an asset?
Unearned revenue is the revenue that is received from a customer as payment in advance, for goods or services that have not yet been rendered. This amount is recorded on the right column of a company’s balance sheet in the deferred revenue account, hence, it is considered a liability rather than an asset.
Unearned revenue is recorded as a liability because the transaction for which the payment was made has not been completed. The company to whom the prepayment was made to has the obligation of providing goods or services to the customer that has made the prepayment. As a result of this, unearned revenue is mostly classified as a short-term liability on a company’s balance sheet.
This classification changes if the prepayment is for goods or services that will be provided in more than one year from the time of prepayment; in this case, the unearned revenue is recorded as a long-term liability. A short-term liability is one that has to be paid within a year, meaning that the goods or services prepaid for must be delivered within a year.
Furthermore, unearned revenue is not an asset because assets are resources the company owns or is owed whereas, in the case of unearned revenue, it is the company that owes goods or services to the customer, hence making it a liability. If the goods or services will be delivered to the customer at once, the revenue gets recorded on the company’s income statement once the delivery has been completed. If the goods or services will be delivered gradually over an extended period, the amount for the delivered part gets recorded as revenue until all the goods or services have been delivered.
Businesses that receive upfront payments for goods and services must ensure that they deliver the goods and services to customers when due. This will aid in driving customer satisfaction, increase customer retention rate as well as make the company have a good standing with its customers. Businesses that commonly generate unearned revenue are newspapers, clubs, magazines, and software providers.
Although the income generated from unearned revenue could be considered an asset to the company since it can be used for various operational activities, unearned revenue itself is a liability since the goods or services have not yet been delivered.
Accounting for unearned revenue
Understanding how unearned revenue impacts a company’s book is an important financial component. The unearned revenue is recorded as a liability on the company’s balance sheet until the goods or services that have been prepaid for are received by the customer. After the customer has received the goods or services, the revenue is now considered earned and is recorded on the company’s income statement.
On the balance sheet, the unearned revenue is recorded as a debit to cash and credit to unearned revenue at the time of the prepayment. This increases the balance of both the cash and the unearned revenue accounts. When the good or service is delivered, and the revenue is earned, it is recorded as a debit to unearned revenue and a credit to revenue. This reduces the unearned revenue account and increases the revenue account.
For example, if a book club accepts yearly subscription payments of $2,400 from its members in the hope of providing new books to them each month, the book club will record this income as unearned revenue on its balance sheet. It will also be considered a short-term liability since its duration is only a year. Additionally, the book club will make a journal entry that will look like the one in the table below
As the months pass and the book club delivers books to its members, the unearned revenue account will be decreased by the monthly equivalent of $200 ($2,400 divided by 12 months) that has been earned, and the revenue accounts get credited by the same amount. Furthermore, the $200 will now appear on the book club’s income statement as revenue. The journal entry for the earned amount will look like the table below
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From our discussion, we have seen that unearned revenue is not an asset, it is rather a liability because the company owes the customer goods or services. This amount is often recorded on the company’s balance sheet in the liabilities section as deferred revenue. In order for the company’s balance sheet to be balanced and well reported, the unearned revenue involves two accounts, the cash, and unearned revenue accounts. A debit is made to the former and a credit to the latter.
Unearned revenue is useful in daily business operations and productive investments. It can also offer information about a company’s future revenue since the unearned revenue translates to revenue for the company once it is earned. Additionally, GAAP principles will be broken if revenue earned is not recorded in the same accounting period as when the expenses for it are paid. Hence companies record unearned revenue as a liability since they still owe the amount prepaid if they fail to fulfill their obligation to provide the goods or services.