Unearned or Deferred Revenue

A Comprehensive Guide to Unearned Revenue for Small Businesses

As a small business owner, one term you’ll commonly encounter in accounting and financial planning is “unearned revenue.” But what exactly does it mean and why does it matter?

In this in-depth guide, we’ll demystify unearned revenue, how to account for it, and key strategies to leverage it to strengthen your business finances and cash flow. Let’s dive in.

Defining Unearned Revenue

Unearned revenue, sometimes called deferred revenue, refers to customer payments received in advance of delivering a product or service. It’s essentially money you’ve been paid but haven’t yet earned through completion of work.

Common examples include:

• Prepaid annual subscriptions
• Advance deposits for projects
• Upfront retainers for services

Unearned revenue is crucial to understand because it impacts everything from your tax liability to cash flow planning and revenue recognition practices.

Accounting Treatment of Unearned Revenue

When a customer prepays for a future purchase, you must record the payment as a liability on your balance sheet, not yet as earned revenue. Here’s why:

You have received cash from the customer, satisfying your end of the transaction. But until you deliver the product or service, you have an outstanding obligation to the customer. This creates a liability that remains on your books until fulfilled.

Let’s walk through an example:

• Customer signs 1-year, $5,000 contract for your SaaS service starting next month
• You invoice $5,000 upfront on signing
• Customer prepays the full $5,000 invoice

Here’s how to record the unearned revenue:

Debit Cash: $5,000 Credit Unearned Revenue: $5,000

This records the upfront cash inflow but as a liability, not revenue. It reflects the fact that you still need to deliver the service over the next 12 months before considering this earned revenue.

Over the course of the year as you provide the SaaS access month-to-month, you reduce the unearned revenue liability and recognize monthly revenue . For example:

Debit Unearned Revenue: $417
Credit Revenue: $417

This releases 1/12th of the prepaid contract value from the unearned revenue liability as you fulfill your obligation month-by-month.

On the balance sheet, the unearned revenue liability decreases while on the income statement revenue is recognized. This process continues until the liability hits zero, indicating the contract has been fully serviced.

Why Unearned Revenue Matters

While an accounting liability, unearned revenue offers important benefits:

• Cash flow – Customer prepayments provide cash upfront before you deliver work. This aids cash flow management and covers overhead.
• Working capital – The liability cushions your working capital needs by providing cash to fund operations before you earn it. This can fund growth.
• Commitment – Prepaid contracts incentivize customer retention and project completion.
• Revenue smoothing – Payment scheduling allows you to smooth out and stabilize revenue recognition over longer periods.

In summary, unearned revenue enables you to collect cash earlier while matching revenue earned to obligations fulfilled.

Unearned Revenue vs Deferred Revenue

Unearned revenue and deferred revenue refer to the same underlying concept – cash received before revenue recognition. The terms are interchangeable.

However, deferred revenue more precisely explains the mechanism – you are deferring revenue recognition to a future period when goods or services are delivered.

Some argue unearned better captures the essence that the business has not yet earned the revenue and still owes an obligation back to the customer.

In practice, both terms are commonly used to describe this prepaid liability concept. Choose whichever resonates most with you.

Strategies to Optimize Unearned Revenue

As a small business owner, here are some strategies to leverage unearned revenue for stronger financial performance:

• Charge deposits – Require 10-20% deposits from customers upfront when feasible to aid cash flow.
• Offer installments – Allow customers to pay in installments over longer projects rather than 100% upfront. This improves affordability.
• Incentivize prepayment – Provide discounts for customers who agree to pay full contracts upfront rather than monthly/quarterly.
• Build recurring revenue – Transition to subscription models that facilitate upfront prepaid contracts for recurring services.
• Show value first – If charging upfront is not viable for your business, demonstrate value fast so customers willingly prepay over time.
• Automate billing – Use automated billing software to securely process and track recurring unearned revenue installments.
• Forecast unearned – Factor both existing unearned liability balances and projected unearned revenue into cash flow forecasts.

With the right strategy tailored to your business model, unearned revenue can provide a key asset in managing financial performance.

Unearned vs Deferred Revenue on Financial Statements

On your core financial statements, unearned revenue is reflected as follows:

• Balance Sheet – Shown as a liability under Accounts Payable and Accrued Expenses. The unearned revenue balance decreases over time as amounts earned.
• Income Statement – Not reflected initially. Recognized incrementally as revenue over time as obligations are fulfilled.
• Cash Flow Statement – Upfront receipts show in positive operating cash flow. Amounts unearned are adjusted out of net income for accrual accounting.

Unearned balances should be clearly tracked on your balance sheet schedule. Revenue recognition timing is also vital for accurate financial reporting.

Accounting for Unearned Revenue with Accruals

Under accrual accounting, unearned revenue is crucial for proper revenue matching and accurate financial statements over time. Here are key considerations:

• Revenue must align to delivery of goods or services, not merely cash receipt. Unearned revenue facilitates this matching process.
• Earned revenue is recognized incrementally against the unearned liability balance as performance obligations are satisfied.
• Unearned revenue adds a layer of accounting complexity to ensure timing is tracked accurately.

Without unearned revenue, revenue recognition would incorrectly show huge spikes in periods with upfront customer payments. This distorts financial performance visibility until earned.

Taxes on Unearned Revenue

Unearned revenue also impacts your tax liability and planning:

• Taxes are NOT owed on unearned revenue until the related goods/services are provided and it becomes earned revenue. Payment timing does not determine taxability.
• However, estimated quarterly tax payments may still need to be made on unearned receipts to avoid underpayment penalties. Proper projections are key.

Work closely with your accountant to ensure unearned revenue is treated properly for tax purposes in accordance with GAAP revenue recognition standards.

Key Takeaways

• Unearned revenue refers to customer payments received before obligations are fulfilled.
• It is recorded on the balance sheet as a liability, not yet revenue.
• Recognition as earned revenue occurs incrementally as goods/services are delivered.
• Strategically leveraged, unearned revenue strengthens cash flow and provides working capital.
• Managing its accounting and tax treatment involves additional diligence.

With the right financial controls, unearned revenue can provide a key asset in managing your small business finances.

For small business owners without large finance teams, properly tracking unearned revenue across the accounting cycle and financial statements can be a major challenge.

Fiskl provides an automated revenue recognition management solution that handles the heavy lifting for you. By automating unearned revenue accounting, Fiskl provides the visibility and controls needed for accurate financials, cash flow planning and revenue projections.