Deferred (Unearned) Revenue – Definition and Accounting Procedures

Deferred or unearned revenue is an advance payment made by a customer for a product or service that has not yet been rendered (delivered). It is a very common economic transaction. When you book and prepay for your airline ticket, the flight service records this as unearned revenue. Once you board the plane and land at your destination, the airline converts this dollar amount to sales. Another common example is when a concert goer purchases their tickets in advance. The entertainment group books the pre-sales as unearned revenue and once the concert is completed, the unearned revenue is transferred to the revenue section of the income statement.

What is the business definition of deferred revenue and then how do we book or account for the transaction? The following two sections define the term ‘Deferred Revenue’ and then illustrate how the transactions are accounted for in the books of record. It is illustrated below how it looks on the balance sheet and then how it is transferred to the income statement once the prepayment is earned.

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Business Definition of Deferred (Unearned) Revenue

Before defining deferred revenue, an understanding of the terms used is necessary. With accounting, accountants use the term unearned revenue on a balance sheet in the liabilities section. The term ‘Deferred Revenue’ means exactly the same thing except it is more commonly used as it relates to tax return preparation, i.e. the IRS prefers this term over ‘Unearned Revenue’. Some accountants will use the two terms interchangeably while others are more technical with its respective definition.

For those technically oriented accountants, deferred revenue has a longer period of recognition to the income statement, i.e. the revenue is earned in increments over several accounting cycles (monthly) whereas unearned revenue will be earned within the next accounting cycle. For the small business owner, either term is acceptable. Pretty much any common layman will understand what you mean when you use either term. For the purposes of this article, both mean the same and for the purpose of this article, only use the term ‘Unearned Revenue’ is used from this point forward.

To explain the proper accounting principle of unearned revenue, the reader needs to understand two concepts. The first is legal and it relates to contract law. The second is the accounting concept of accrual accounting. Let’s review these two concepts:

Contract Law – in a simple contract, both the buyer and seller agree to some terms of exchange, i.e. I pay you $20, you hand me a widget. In order for a contract to be valid, one of the two parties must act. Traditionally the widget maker, hands over the widget to the customer and the customer now owes for the widget. However, sometimes the customer prepays for the widget. In this situation, the widget maker (you) owe a widget to the customer.

Accrual Accounting – this is the Generally Accepted Accounting Principle used in advanced accounting. Although not a law or requirement for small businesses, accrual accounting is considered the preferred method of accounting. Accrual accounting is required by the Securities and Exchange Commission for publicly traded companies.

Many small businesses use cash accounting whereby when the cash is received, the revenue is booked to the profit and loss statement, i.e. it shows up in revenue. However in a situation when the customer prepays for the widget, it doesn’t reflect the matching of costs to the revenue as a reader of a profit and loss would like to see and understand. Accountants use accrual accounting whereby the cash receipt is booked as unearned revenue and then when the widget is delivered, the unearned revenue is transferred to the profit and loss statement into the revenue or sales section of the report.

Now you understand the two concepts that underlie the accounting principle related to unearned revenue. When a customer prepays for the service or product, the cash receipt is classified as a liability and recorded to the balance sheet. Why a liability? Well, think about this for a moment; go back to the contract law above. The customer performed in accordance with the contract, i.e. he paid for the service or product. Therefore, you the seller owe him the service or the product or you have to give him his money back. This is defined as a liability, what is the value? It equals the amount the customer prepaid. In our example above, it is $20.

Since the customer has prepaid for a product or service, we classify this as unearned revenue. However, there are many circumstances where a customer pays money to the seller and this is not unearned revenue. In many situations, customers prepay for a ‘Potential Product or Service’. A perfect example is a deposit on a lease of real estate. The landlord desires to have some type of security for the future if you should damage the property (the potential issue). This is not unearned revenue as it has nothing to do with the rent itself, the rent relates to using the property, the deposit relates to an issue of repairing damages you may inflict to the property. Therefore, deposits are not recorded as unearned revenue. However, the deposit is recorded as a liability for the landlord, just a different type of liability in comparison to unearned revenue.

There are multitude of examples of prepaid fees for products and services and therefore the seller/provider should book this money as unearned revenue. This assumes that the seller/provider uses accrual accounting in their accounting process. The following are some of the common forms of prepaid transactions:

Contractors generally require a buyer to post a ‘Deposit’ on a contract. In reality this is actually unearned revenue. Depending on the terms of the contract, this unearned revenue can be allocated or prorated over the life of the contract to the profit and loss statement or considered earned at some point in the early stages of construction. The contract terms determine the exact point where the ‘Deposit’ is transferred to revenue on the income statement.
Large ticket items such as planes, ships, cranes, specialty transportation equipment, real estate development and manufacturing equipment purchases require a ‘Deposit’ which is really unearned revenue. This is considered a good faith prepaid fee (earnest money) on a contract. If the buyer fails to complete the transaction, the seller’s contract stipulates forfeiture of the deposit and this is then booked as revenue.
In apartment complex accounting or condo accounting, many tenants prepay their rent for the next month or for several months later. This is considered unearned revenue.
Gift cards purchased by customers for restaurants, I-Tunes, or for other products are considered unearned revenue by the provider of the products.
Professional service businesses (lawyers, accountants, architects) often require a retainer. Retainers are unearned revenue.

As a small business owner, there are exceptions to the rule. If you sell a product or service to a customer and you know that that service or product will be delivered within the current accounting period, then don’t go through the transaction process to book it is as unearned revenue and then make the transfer to revenue on the income statement. Just book the transaction as revenue immediately. Don’t do double the work just to be technically correct. Examples include customers giving down payments for the purchase of cars, appliances, home services, or retail products.

Accounting Process

How does the accountant record unearned revenue? What does the accountant do once the contract is completed or the money prepaid is actually earned? The following illustrates this process:

Step 1 – Record the Funds as Unearned Revenue

Remember from above, money advanced to the seller from the buyer creates a contractual obligation between the two parties. The seller has a liability to the customer to either deliver a product/service or return the money. A liability is a balance sheet line item in the bottom half of the balance sheet. In general, unearned revenue is located as one of the lower lines in the current liabilities section as illustrated below:

XYZ, Widget Company
Balance Sheet
December 31, 2013

Assets
            Current Assets $ZZ,ZZZ
            Fixed Assets ZZ,ZZZ
            Other Assets      Z,ZZZ
            Total Assets $ZZZ,ZZZ

Liabilities & Equity
            Current Liabilities
                        Accounts Payable         $Z,ZZZ
                        Accrued Payroll Z,ZZZ
                        Revolving Credit Z,ZZZ
                        Unearned Revenue    Z,ZZZ
  Total Current Liabilities ZZ,ZZZ
   Long-Term Notes   ZZ,ZZZ
            Total Liabilities ZZ,ZZZ
   Equity    ZZ,ZZZ
            Total Liabilities & Equity $ZZZ,ZZZ

In the actual accounting ledger, the entry is to debit Cash (for the amount of the cash received) and credit Unearned Revenue for the same amount.

Step 2 – Transfer the Earned Amount to Revenue in the Profit and Loss Statement

Once the terms of the contract or agreement are complete, i.e. you deliver the product or service it then becomes time to reclassify the unearned amount as earned. In this situation, you will debit the Unearned Revenue account and credit the Revenue or Sales account associated with the product/service rendered.

In principal, the entry to the books lowers the liability amount on the balance sheet by the amount actually earned by the seller. Then on the income statement (a.k.a. the profit and loss statement), the sales line in the revenue section increases by the same amount. This is achieved via the sales journal in the accounting ledgers or it can be done via the general journal. With modern accounting software, this is often achieved via the sales journal so the customer’s history is updated. Now the balance sheet should look like this:

XYZ, Widget Company
Balance Sheet
January 31, 2014

Assets
            Current Assets $ZZ,ZZZ
            Fixed Assets ZZ,ZZZ
            Other Assets       Z,ZZZ
            Total Assets $ZZZ,ZZZ

Liabilities & Equity
     Current Liabilities
                        Accounts Payable   $Z,ZZZ
                        Accrued Payroll Z,ZZZ
                        Revolving Credit   Z,ZZZ
                        Total Current Liabilities ZZ,ZZZ
Long-Term Notes   ZZ,ZZZ
            Total Liabilities ZZ,ZZZ
Equity ZZ,ZZZ
            Total Liabilities & Equity $ZZZ,ZZZ

Notice the Unearned Revenue line is now gone. The profit and loss statement should never have an unearned revenue line in the revenue section. Unearned revenue is strictly a liability and found on the balance sheet.

Now for those businesses receiving unearned revenue, this line on the balance sheet is customarily there and almost always has a value. Normally in our situation above, the unearned revenue line would have decreased by the amount that was earned or transferred to the income statement. In reality, this line’s value fluctuates from month to month.

Advantages and Disadvantages

Believe it or not, this is one line item in the liabilities section banks love to see! It informs the reader that at some point in the near future, revenue is going to get booked on the profit and loss statement. In addition, this is really an interest free loan from your customer to finance your operations. Think about the economic transaction here, someone hands you cash and you owe them the money back or a physical widget (service). How is this any different than a loan from a bank? The only difference is you don’t owe the bank a widget (bank’s don’t like widgets, they only love cash). The other advantage is that the customer prepayment will show up as a sale in the future. For the owner of the company, this is great news.

As with most issues in life, although there are advantages, there are disadvantages. If a customer prepays for the widget, you now have an obligation to the customer. Not a real big problem if you are in the business of reproducing the widget regularly and with good quality. But often, prepayments are for customized items and if you fail to deliver, you must pay back the money. I often caution owners to reserve the cash or restrict the cash in order to prevent its expenditure. In many industries, this is legally required. The most common are licensed operations such as property management and government contracting work.

Another disadvantage develops if the unearned revenue line grows faster than the company’s growth rate. This is a warning to the owner that production is having difficulty keeping up with orders from customers. At some point, customers are going to get upset with management about the inability of the business to deliver the product (service). As an owner, you should pay close attention to the growth rate of unearned revenue.

Summary – Deferred (Unearned) Revenue

Unearned revenue is generated because of two accounting concepts. Contract law and accrual accounting obligate the business to process the transaction as a liability to the balance sheet. Once the product or service is delivered, the bookkeeper then decreases the liability on the balance sheet and records the amount to sales on the income statement. Not many businesses get to utilize this form of accounting and it generally has more positive attributes than negative ones. It is actually a good thing to have customers prepay you for your work. There is always some apprehension involved when a customer owes you money after you have delivered the product or service. Getting cash upfront on any sale is good news.

If you receive cash before delivering the product and most likely the product or service will not be delivered until a future accounting period, it is best to record the transaction as a liability and then once earned, transfer the dollar amount to sales on the income statement. Act on Knowledge.