When customers pay you for goods and services that you’ve provided, the money is considered earned revenue. But what happens when your customer pays you a year in advance for services that you haven’t yet provided?
That’s considered unearned revenue, and there’s a special way to record it.
Overview: What is unearned revenue?
It’s always great to be paid in advance for goods and services yet to be delivered. However, until those products or services have been provided to your customers, any money received in advance is considered unearned revenue.
If you provide subscriptions or services, you or your bookkeeper will likely be recording unearned revenue on a regular basis. In addition, property management companies, insurance companies, and other companies that require an advance payment frequently need to record unearned revenue.
This is because according to the revenue recognition principle, revenue should be recognized in the same period in which goods or services are provided.
If your customer pays you a year in advance for your editing services, you can only recognize the revenue for the month in which goods and services have been provided.
The balance of the money paid early will remain in the unearned revenue account and should only be recognized as the goods and services are provided each month.
An example of unearned revenue
For instance, if your customer pays you $12,000 in January for professional services for the year, only $1,000 of that payment will be considered earned revenue for the month of January, with the other $11,000 considered unearned revenue.
Each month, a portion of the unearned revenue remaining in the account will be recognized as revenue as the goods and services are provided. If you’re using accounting software, you can create a recurring journal entry for each month, eliminating the need to create a separate entry each month.
Unearned revenue vs. accrued revenue: What's the difference?
Unearned revenue, sometimes referred to as deferred revenue, represents advance payments a company receives for goods or services that have not yet been provided. Using accrual accounting, or double-entry accounting, you’ll need to record unearned revenue as a liability.
Unearned revenue liabilities will appear on your balance sheet until goods and services for the period are provided to the customer(s) who have paid early. At that time, the unearned revenue will be recognized as revenue on your income statement.
The journal entry to record a prepayment would be:
By posting the payment to the unearned revenue account, the revenue will not be recognized until the goods or services are provided. On January 31, to recognize revenue for January, you can record the following unearned revenue journal entry:
Because services have been delivered for January, you can recognize the amount of revenue that should be allocated to January, which is $1,000. The balance of the $12,000 payment remains in unearned revenue until goods and/or services have been delivered for February.
This journal entry should be recorded monthly until the revenue for the entire year has been properly recognized.
Accrued revenue is the revenue you’ve already earned by providing goods and services to your customer, but have not yet received payment for.
Your accounts receivable balance is considered accrued revenue because, again, according to the revenue recognition principle, revenue should be recorded in the period in which goods and services were provided. You’ll record your accrued revenue as follows:
By crediting the revenue account, you’re recognizing it when it’s earned, and you'll reduce the accounts receivable account when the bill is paid:
How to record unearned revenue
Unearned revenue accounting is a simple process. Let’s work through another example of how to record unearned revenue.
On January 15, you receive a payment in the amount of $15,000 from one of your customers. The payment represents editing services you'll be providing for the months of February, March, and April. You'll need to record the initial payment as follows:
You don’t need to recognize any revenue in January because your services do not start until February. Your next journal entry will be as follows:
The journal entry represents payment for the goods and services (editing) that you provided in the month of February. You'll record the same journal entry for March and April as well.
Recognize and record your revenue properly
Accounting for unearned revenue is a simple, two-step process: recording the initial payment, and then recording an adjusting entry when the revenue is earned.
What happens if you don’t record unearned revenue properly? Improper revenue reporting may not affect very small businesses, but it can definitely affect larger businesses.
Perhaps the biggest impact would be inaccurate financial statements, with revenue totals overstated in the month when the prepayment is received, and understated in all subsequent months.
Accurately recording your unearned revenue will help keep your books straight and provide valuable insights into the health of your business.