Unearned revenue for small business owners

Unearned revenue affects your financial statements, assets and liabilities. Here’s what you need to know about unearned revenue and how to record it in your financial statements.

Defining unearned revenue

Unearned revenue, also referred to as deferred revenue or unearned income, is money your customer pays you for goods or services you haven’t yet delivered.

Unearned revenue is common in many industries because it:

• boosts a business’s cash flow so a business can cover its expenses or reinvest
• can offset the costs of goods and services that are expensive to produce
• reduces the risk of customers not paying their invoices, as customers who pay upfront may be more committed

It’s important to properly record unearned revenue to make sure your tax records are up to date, and so your stakeholders have a clear view of your financial position. See our advice below.

Unearned revenue examples

• Travel: People usually pay for airline tickets, hotel bookings and event tickets ahead of their travel.
• Accommodation: Renters often pay landlords weeks or months ahead.
• Subscription services: Providers of digital software, newspapers and online streaming services typically charge annual subscriptions.
• Contract services: Contractors and service providers like painters, copywriters and caterers may request payment before starting work.
• Professional services: Law firms, for example, may use unearned revenue by charging a retainer before they start work.
• Insurance: Insurance companies often use unearned revenue by charging premiums for a year. The policyholder pays for a year upfront and receives insurance cover throughout the year.
• Online shopping: Online retail companies charge fees for goods before the goods are shipped.

Unearned revenue vs other revenue types

Unearned revenue affects your financial reporting differently from other types of revenue, so it’s important to understand the difference between them:

• Accounts receivable refers to money clients owe your business for offerings you’ve already delivered. For example, if you’ve served and invoiced a customer, but they have not yet paid for it, this payment is part of your accounts receivable.
• Retained earnings is your business’s accumulated net income that remains in the business after all direct and indirect costs, taxes and dividends are paid. You can use the retained earnings to grow your business.
• Prepaid expenses refers to payments your business has made in advance for goods or services you will receive in the future.
• Accrued revenue is revenue your business has earned but has not been paid for (and you may not have yet invoiced for). For example, if you have a website design business, you may have created pages for a client but have not invoiced them yet.

Recording your unearned revenue

Properly tracking your unearned revenue helps make sure your financial statements are up to date. Although accounting software like Xero automates this process, it’s useful to understand how the process works in your bookkeeping so you can monitor your unearned revenue.

A couple of general points:

• Most businesses in Canada must use IFRS standards for financial statements.
• Accrual accounting is the accounting method preferred by the Canada Revenue Agency (CRA).

In accrual accounting, you record transactions at the time they occur, often before you receive money. If someone buys a product from you in December but doesn’t pay until March, you still record it as revenue earned in December.

How to record unearned revenue in your financial statements

• When you receive unearned revenue, record it in the cash or bank account, and in either the unearned revenue account or the deferred revenue account. Once you deliver the goods or services, deduct the amount from the deferred revenue account and increase the revenue account.
• Unearned revenue appears as a liability on the balance sheet because you are obligated to fulfill that order in future. For example, you might offer a 1-year software subscription; once the client pays you, you must fulfill the agreement over the year. As you do so, the unearned revenue is gradually recognized as revenue.

If you expect to deliver the goods or services within a year, treat unearned revenue as a current liability. If it will take longer than a year, you may list it as a long-term, non-current liability.

• Don’t record unearned revenue on your income statement until you earn the income – you only record revenue that you’ve earned during the relevant period.

Journal entries

In a double-entry bookkeeping system, each transaction has two entries.

When you get paid for goods or services you haven’t provided, you first record it in an asset account – typically a cash or bank account. You also record it in an unearned revenue or deferred revenue account.

• Credit: unearned revenue account
• Debit: cash account

Once the transaction is complete and the customer has received the goods or services, you need to adjust the journal entry. For the adjusted journal entry, record unearned revenue as a debit, and record the credit in the asset account.

How unearned revenue affects your working capital

Working capital is the difference between a company’s current assets (what the company owns that adds value to it) and its current liabilities (what it owes).

When your business receives a prepayment its cash increases, which in turn increases its current assets. At the same time, you record the unearned revenue as a liability for the same amount. This means there is generally no net change in your working capital until you deliver the goods or services and the revenue is recognized.

For example, if you receive $240 for a 1-year subscription, your cash increases by $240 and your liabilities also increase by $240. Each month, your revenue increases by $20 (and your liabilities decrease by the same amount) as you deliver your subscription.

If you don’t adjust your journal entries, it distorts the appearance of cash flow and the financial health of your business – you might seem to have higher liabilities or less revenue than you do – and it can also affect your taxes. This is why it’s important to accurately record and adjust your books as you record unearned revenue.