As a business owner, you know that it’s important to keep track of your finances and one key metric is unearned revenue. This figure represents money that has been paid by customers for goods or services that have not yet been delivered. While it may seem like a small thing, knowing how to calculate unearned revenue is important for business owners since it helps them understand the financial health of their business.
This article teaches you how to calculate unearned revenue, but first, let’s understand what unearned revenue is.
What is Unearned Revenue?
Unearned revenue is the advance payments which a company receives before the actual delivery of the product or service. This could include payments for products which are yet to be delivered or for services which have not been rendered.
Revenue that has not yet been earned is unearned revenue and is classified as an accrued expense. This means that the transaction has taken place before the delivery of goods and services. As such, no income is recorded by the company until the goods are delivered.
It is a type of accounting under which a company gets paid before providing goods or services. Under this, the exchange of money takes place before the actual delivery of goods and services, and as such, no income is recorded by the firm.
The company must deliver on its promises to customers.
Referred to as unearned income, deferred revenue is an advance payment for goods and services that will be provided at a later date.
Deferred Income is the money that you receive for products or services that you haven’t provided yet. This is common in industries like insurance, where customers pay in advance for coverage.
Unearned Revenue Is a Liability on the Balance Sheet
This “unearned” or “accrued” income on the income statementIncome StatementThe Income Statement (or Statement of Profit and Loss) shows performance from operations of a business. The financial statement begins with revenues and, and expenses.
A balance sheet is an accounting tool used to list a company’s assets, debts, and owner’s capital. The sum of all current and long-term debt, as well as all short-term and non-current obligations, must equal the sum of all the company’s current assets and all long-term and non-current investments.
Unearned revenue is money that a company expects to receive in the future but has not yet received. This is usually for services, such as subscriptions, that have already been provided.
For example, we note how salesforce.com lists their “unearned revenues” as a current asset.
Source: Salesforce’s 10-K filing
How To Calculate Unearned Revenue: Unearned Revenue Accounting
When a business receives a payment for the products or services it will deliver in the future, it increases its cash on hand. This is because the good or service will be delivered later, so the undelivered income is counted as an asset on the balance sheet. This increase in assets is balanced by the increase in liabilities, so both sides of the company’s balance sheet are increased.
Let us now look at the basics of how accounting and bookkeeping work.
Company XYZ will pay $12,000 to a company named “MNC” for 12 months of maintenance. How will this be recorded on the balance sheet?
It’ll look like
After one month of working, $1000 of earned and $1000 of unearned income from XYZ will be recognized.
Thus, $ 1000 of unbilled services will be recognized.
The Shareholders Equity section of the Profit and Loss Account will be affected by service revenue.
The Shareholder’s Equity statement shows the change in the value of the company’s assets, liabilities, and shareholder investments from the start of the accounting year to the end. This is very important for stakeholders and investors to understand the performance of the company.
When looking at a business, it is important to consider its unearned revenue. This shows how much growth the business has.
The level of unpaid income is extremely high, which is a sign of the company’s healthy cash flow.
Unearned income, or revenue, is an important part of accounting and financial planning. This type of income is not earned until a later date, and as such, it does not result in an immediate cash outflow. Instead, unearned income is recorded as a liability on the balance sheet.
When the goods or services are eventually provided, the unearned income is recognized as revenue on the income statement.
Deferred revenue is common in industries where customers pay upfront for products or services. This includes airlines, insurance companies, law firms, and magazine publishers.
Airlines typically receive payment from customers who book their flights in advance.
Although the date of departure may be in the future, the same reporting requirements apply to businesses within a specific industry over a specified period of time (e.g., quarterly, six-monthly or annually).
The balance sheet, income statement, cash flow statement, and shareholders equity statements are all prepared according to standard and regulated procedures.
#1 – Liability Method
When a business receives deferred revenue, it creates a liability account to track the amount it has yet to earn. This is the basic premise behind using the liability method to report unearned sales.
The liability method is the most common way businesses report unearned sales. This is because the amount of revenue earned has not yet been determined. The deferred revenue account is typically used for this purpose.
#2 – Income Method
Under accrual accounting, when a business earns revenue, it records the full amount as income. Then, as it delivers goods or services, it adjusts its books accordingly.