In accrual accounting, it is important to organize income properly. Especially when it comes to prepaid services. Prepayments are considered unearned revenue. But, hold your horses! You cannot instantly take in this type of revenue as income. Unearned revenue is a liability and is treated in a very unique way.
In this article we will take a deep dive into unearned revenue:
- What is unearned revenue?
- Why is unearned revenue a liability?
- How to record it under best accounting practices
- ASC 606 compliance
- How to recognize deferred revenue in Xero
- How to set up a prepaid revenue schedule
- Correcting premature revenue recognition
What Is Unearned Revenue?
Unearned revenue is prepayment for services or goods. It goes by all of these names:
- unearned income
- prepaid revenue
- deferred income
- deferred revenue
Unearned revenue is a liability. This type of revenue is like a hot potato. Even though a payment has been received it is not considered income immediately. So it stays on your balance sheet until services or products are delivered. It is good accounting practice to keep it separated in a deferred income account. Since the deliverable has not been met, there is potential for a customer to request a refund.
This type of income is contractually based. With the provider and customer agreeing to delivery of a services or goods, at a specified time, for a specified price. These contracts will always cross over into another accounting period, often spanning a year or longer. Contract terms, fees, and requirements must be outlined and adhered to.
Examples of Businesses with Unearned Revenue:
- Software as a Service (SaaS) – Apps, Netflix, Adobe Creative Suite, etc
- Legal Retainers
- Advance Rent
- Airline, Sports, and Events tickets
- Prepaid Insurance Premiums
- Contract Work
- Real Estate
- Travel Agencies
- Magazines or Newspaper Subscriptions
- Weddings and Catering
- e-Commerce Product Pre-Orders
Assets Vs Liability: Why Is Unearned Revenue a Liability?
Unearned revenue is NOT a current asset but a liability. It is a contractually based payment for future service. Since service is owed, it is considered a short-term or long-term liability. Once revenue recognition occurs, it is earned revenue and becomes income.
Assets: money a company owns or will receive in the future
Liabilities: money a company owes
Unearned revenue is distinctly different from current assets. Current assets are receivables that a company will get within a year. They hold no official contracts, only a receipt or invoice. Generally, they are transactional where money is exchanged for a service/good in real-time.
Unearned Revenue on the Cash Flow Statement
Financial stability can be measured via cash flow. It is an indicator that a business has the money to manage costs, fund investments, and reap sizable profits. With unearned revenue on the cash flow statement, you get a sense of the immediate future.
Due to the revenue recognition process, cash flow and income are not inherently linked. You can have deferred revenue on the cash flow statement without income, you can also have income without inflows of cash.
Deferred Revenue Accounting
Below is everything you need to know about deferred revenue accounting. We will detail: compliance, how to set up a deferred revenue schedule; the process of prepaid revenue recognition with a separate liability account to track the inflow of prepayments. The main theme is to move this money correctly from liability to income.
Deferred Revenue Recognition Compliance
As stated above prepayments are coupled with contracts. Contracts between provider and customer should be strictly followed. Any premature recognition of income is considered “creative” or “aggressive accounting.” A move, subject to penalty by the Securities and Exchange Commission (SEC). Follow these steps for deferred revenue recognition:
- Review the contract with the customer in the form of an invoice, to show payments or fees applied to service or goods.
- Address the business’s obligation to make sure all deliverables are met.
- Determine the appropriate cost and expense estimates, to perform specific service tasks.
- Deduct that amount from the prepayment.
- Recognize revenue when services or goods have been performed.
ASC 606 Revenue Recognition Standard
ASC 606 aka Topic 606 are rules for revenue recognition, for GAAP companies. These rules are formulated to normalize revenue recognition so that reporting is simplified and clear. ASC 606 structures all contracts in the same way. So that every change to every contract, is suitably accounted for. Note: this is a nuanced form of accounting—a company could make thousands of journal entries affecting deferred revenue recognition.
ASC 606 standards will affect:
- Customers with multiple types of contracts like “seats” or “add-ons”
- Fluctuating expenses related to services
- Special discounts
- Cancellations, refunds, and fees
Not all companies have to comply with the specific requirements of ASC 606. But it is highly recommended for businesses working toward becoming a public company or attracting serious investors.
What is an Unearned Revenue Schedule?
A deferred revenue schedule is based on the contract between customer and provider. The contract will dictate when payments are due and when deliverables are to be met. In your accounting, you will schedule unearned revenue adjusting entries to match these dates. Scheduling these entries will organize and automate deferred revenue recognition.
In the case of subscription services, revenue installments are made at different times during the contract. For annual contracts, a prepayment is made at the beginning of the period. A business then would perform the service monthly and recognize a certain amount of revenue each month.
How to Create a Deferred Revenue Schedule in Xero?
These steps are specific to Xero, but the process is generally the same for any cloud-based accounting software. Manually setting up a deferred revenue schedule enlists three areas in Xero: Prepayments, Manual Journals, and Invoicing. Start by receiving the prepayment into your bank feed:
- Go to your Accounts
- Select the prepayment in your bank feed
- On the right side of the dashboard go to the Create Tab
- Click add details
- In the Spent As dropdown select “Prepayment”
- Fill in the description as your “Prepaid (service/good)”
- Select your deferred revenue account
For each serviced installment, you will need to link the contracted amount to an invoice. Set up repeating invoices for the remainder of the contract:
- Click on Accounts
- Select Sales
- Select the +New dropdown box
- Then select Repeating Invoices
- You can make the invoice recurring by selecting the time it will be sent out.
- Then set the end day for the last installment of the contract
- Balances are $0 (since they have already prepaid)
You then will need to create a journal entry linked to each invoice. This will direct the money out of the account and recognize it as revenue.
- Go to the Prepayment
- Select allocate credit
- Choose the invoices you would like to apply
- Enter a credit amount
How to Manually Recognize Unearned Revenue
When receiving prepayments, an unearned revenue adjusting entry is used to report the transaction. Along with numerous future entries, showing the money being incrementally recognized as revenue. We’ll describe this process using the example below:
For Example: A subscription accounting firm offers monthly services for $400. One of their clients re-ups in January. The contract is 12 months of bookkeeping and tax services. The client opts to prepay $4800 for the entire year. Outside of payroll, the accounting firm pays $1200 annually in expenses to service this contract.
A prepayment adjusting entry would be noted on the books for January. The entry would be a debit of $4800 to your cash account. The increase in cash is not considered income yet! You also need to enter a credit of $4800 to the deferred revenue account. This would increase the balance in that account. The subscription for monthly accounting service is considered a short-term liability on the balance sheet.
At the start of February, you need to record the first month of service as income. Think of it as a customer paying for monthly service, but you already have the money. Debit $300 out of the deferred revenue account. This decreases your unearned revenue liability because you performed the service. Next, you credit your sales account for $300
Once deferred revenue recognition takes place, it comes off the balance sheet. It is now income, and shifts over to the income statement. Now it is considered an asset on the balance sheet. In accrual accounting, assets need equal liabilities, in the same period. So you credit your cash account.
Monthly expenses will be treated the same as revenue. The expenses will be divided up and reported in the same period. So $100 will come out of the revenue account and you will credit your expense account $100. The entire process would continue each month of the year. It is important to perform these adjusting entries to recognize deferred revenue according to the contract set in place.
Steps to Recognize Prepaid Revenue:
Here is a review of the steps to recognize deferred income, in the example above:
- Classify unearned revenue as a current liability (within a year) or a long-term liability (longer than 12 months)
- Record money as a credit to unearned revenue and a debit to cash on the balance sheet (both accounts should increase)
- Estimate expenses needed to perform specific service tasks
- Deduct income and expenses from unearned revenue as the job is performed
- Add earned revenue to income
Refunding Unearned Revenue
Unearned revenue is a liability because there is a chance of a refund. Remember revenue is only recognized if a service or product is delivered, a refund nulls recognition. Accounting for a refund differs from a reversal. A reversal, will adjust the liability and move the money through to income, do NOT do that.
Instead, a credit memo is created. A credit memo states the customer no longer owes towards the contract. In the same breath, the seller no longer owes services or products. A credit memo will state the amount to reissue to the customer. The unearned revenue account will then decrease.
Refunds are an important topic to outline in contracts. It is common to refund the remaining portion of funds. It is the seller’s choice to prorate the refund or to charge additional fees. Accounting for unearned fees can be tricky.
First, a credit memo is recorded for the refunded customer. On the same date as the credit memo, you have closed the contract and can recognize revenue from the fee. Note: Unearned fees are not considered normal operational income. They should be classified as “Other Income,” so you don’t skew your revenue reporting.
What to do if you Prematurely Recognized Unearned Revenue?
Mistakes happen. Perform a monthly check of your balance sheet and the income statement. If you have booked revenue too early you will need to start from scratch and recalculate your earnings for all accounts. Improper revenue recognition will result in an overstated revenue account balance, and understated deferred income account balance.
In the event this happens you will need to make a reversal entry. You should always have an invoice to back up the entry. As well as paperwork to prove the re-entered amounts. Get the reversal approved by a higher-up and keep a log of the change. This is proof of a correction, in case any external investigations come your way.
If one employee processes the same transaction from beginning to end, premature revenue recognition is easier to accomplish. Adequate internal control involves the following segregation of duties: order entry, shipping, billing, accounts receivable and general ledger. – The Journal of Accountancy
Fraudulent revenue recognition is something that governing agencies have a hawkeye for. If someone else is managing your books, be aware of aggressive accounting. It shows up in these ways:
- Keeping the books open past the end of the month to log more sales
- Recording revenue before service has taken place
- Delivering product before it has been purchased
- Delivering product to another warehouse and reporting it as a sale
- Holding invoices as liabilities
Unearned Revenue: The Waiting Game
Eventually that deferred revenue will come round, just wait. Number one takeaway: unearned income is a liability on the balance sheet until a service has been performed. When working with prepayments you should always be moving money from a liability account to revenue via a contractual schedule. This marks the amount you earn each month, and keeps you compliant. If you are questioning your reporting, an accountant can help you work out the kinks.