Introduction
Unearned revenue is defined as the payment that a company receives from its customer for providing a service or selling a product, that is expected to be delivered sometime in the future.
The unearned revenue is used in accrual accounting. Accrual accounting does not recognize revenue until the associated products or services are delivered.
Unearned revenue is also known as deferred revenue because the company defers the recognition of the revenue until a later time.
Explanation
The software companies use the accrual accounting method. The subscription-based software uses the Accrual accounting method.
When you buy software that has a subscription-based revenue model, you pay upfront for the software. The subscriptions are usually for a year, but, even though the software companies get paid immediately, the revenue is noted in the balance sheets as deferred revenue.
This is done because, in many subscription contracts, a clause allows the customer to cancel the software subscription.
When the customers cancel the software subscriptions, they are paid back. This means that the company would have to pay back the money.
This is why they use deferred revenue as a metric because even if some subscription gets canceled they could be taken out of the unearned revenue, and then adjusted in the balance sheets after a year passes.
This makes it easy for companies to adjust their revenue only once a year, instead of adjusting their revenue every time a client cancels a subscription.
Example
Consider a company ABC which makes accounting software. It has 1000 subscribers of which 5 subscribers canceled their subscription over the year.
The total unearned revenue of the company was fifty thousand dollars. The five canceled subscriptions mean that unearned revenue showed a decrease of two hundred and fifty dollars.
It means that the new unearned revenue is 49,750 U.S. Dollars. The company ABC can easily adjust the unearned revenue as earned revenue at the end of the year.
When should a company reclassify unearned revenue to revenue?
The unearned revenue is classified as revenue only when a product or service associated with the payment has been delivered to the client, and the client is satisfied. When this is done, the company can recognize unclassified revenue as revenue.
There are two ways to reclassify unearned revenue to revenue. One is on a cash basis, and the second is on an accrual basis.
The accrual basis is used because it also tells that the associated product or service is yet to be delivered. Whereas, on a cash basis, the financial statement can become distorted, as the product or service associated with that cash payment is not recognized.
Methods of reclassifying unearned revenue as revenue
There are two main methods of recognizing unearned revenue as revenue which are shown in figure 1 below:
Figure 1: Methods of recognizing unearned revenue as revenue
The two main methods of recognizing unearned revenue as revenue shown in figure 1 are the Liabilities and income methods. How they work and their detailed explanation is given below:
Liabilities method
The liability method is also known as the accrual method. Under the liabilities method, a liabilities account is opened which tracks all the payments through that account.
In the beginning when a client makes a payment, but the product or service for which he/ she is paying is yet to be delivered, the amount paid is noted into the new liabilities account.
In the Liabilities account, there are two sections: one is credit, and the other is debt. The cash payment received from the client is noted in the credit section, and the product or service which is to be delivered is noted in the debit section.
When the product or service is to be delivered, the debit side exits, and the credit side is officially recognized as earned revenue from unearned revenue on the balance sheet.
Consider a company that organizes events. The company is paid fifty thousand dollars to organize a wedding. The company is using the liabilities method for the unearned revenue.
The company creates a liabilities account and notes the fifty thousand dollars in the liabilities section, because the service, which is a wedding is yet to be organized.
The company then throws a great wedding. The service associated with the payment is done.
The company can then reclassify this amount as earned revenue from the unearned revenue. The fifty thousand dollar payment moves from liabilities to the revenue account in the balance sheet.
Income method
The income method for reclassifying unearned revenue to revenue is exactly the opposite of the liabilities method. In the liabilities method, the unearned revenue is not classified as earned revenue until the associated product or service with that payment is delivered.
But, in the income method, the unearned revenue is classified as earned revenue from the start even if the product or service is not yet delivered, associated with that payment.
In the income method, when a payment is received, it is noted as credit in the balance sheet. But, as the product or service is delivered, and as payments are earned the credit is step by step converted into debit payments.
Consider an example of a company that has signed a contract to construct a 5-mile-long road. One of the contract conditions is that the company would be paid for each mile of road constructed.
The total worth of the contract is 500,000. The company is using the income method to recognize this revenue. Immediately, the company recognizes this revenue.
After a month, it has constructed a mile-long road, it gets paid one hundred thousand dollars, and the company debits this amount from the five hundred thousand dollars.
Now, the credit amount the company has is 400,000. Half a year later, the road is completed. The company is paid the whole amount, and the credit and debit sides become equal.
Frequently asked questions
Does unearned revenue need to be adjusted?
The unearned revenue does need to be adjusted to earned revenue. How and when it is done depends upon a business’s requirements and a country’s regulations. Usually, unearned revenue is recognized as earned only at the end of an accounting period.
In the United States, this is done either at the end of a quarter or at the end of a year. For public companies listed on the stock change, the adjustment period for unearned revenue to earned revenue is usually at the end of each quarter. In contrast, private companies usually do it at the end of each year.
The regulators can grant special permissions to adjust it when the company wants to.
Do you count unearned revenue as revenue?
The unearned revenue is counted as revenue. But, certain conditions must be fulfilled before unearned revenue is classified as revenue.
The very first condition is the payment from the client, and the second condition is the delivery of the product and service which is associated with that payment. When these two conditions are fulfilled, the company is allowed to classify unearned revenue as revenue.
Is unearned revenue a permanent account?
No, the unearned revenue is not a permanent account. It is a temporary account. The unearned account exists only until the unearned revenue is recognized as earned revenue.
The unearned revenue then vanishes. The payments collected in the unearned revenue accounts are transferred to the main account of a company, and the unearned account is no longer required so it vanishes.
The unearned account is only required to hold payments until the product or service associated with the payment is delivered to the client, and the client is satisfied with the delivery. This is the only purpose of the unearned revenue account.
