When can revenue NOT be counted as revenue?
If this question is confusing, you’re not alone. The concept of unearned revenue can easily trip up SaaS companies that offer subscription services and products on a recurring basis.
Unlike when selling ordinary products, you cannot recognize the revenue earned from a subscription all at once. Although your business has received payment, this cannot be credited to your bottom line until delivery of the product is completed. In the case of SaaS subscriptions, this could take several months—or even years.
So, what differentiates ‘earned’ versus ‘unearned revenue’? What accounting rules do subscription businesses need to abide by in order to stay compliant with global standards?
In this guide, we’re going to explore unearned revenue and revenue recognition for subscription businesses and how you can ensure that your business is recognizing revenue accurately.
TL;DR
- Unearned Revenue refers to funds received for goods or services that haven’t been fully delivered. This is important for subscription businesses due to recurring advance payments.
- Revenue recognition for subscription businesses follows the principles outlined in ASC 606, involving steps such as identifying contracts, allocating transaction prices, and recognizing revenue over time.
- Effective management of unearned revenue involves cash flow forecasting, using the right accounting software, and mitigating the risks associated with subscription churn.
What is Unearned Revenue?
Unearned revenue, also known as deferred revenue or prepaid revenue, refers to funds received in exchange for performing goods or services that haven’t been fully delivered to the customer. In sum, it represents an obligation to provide goods or services at some date in the future.
Whenever a business accepts prepayment for services that haven’t been rendered, it needs to follow a different process for recognizing revenue and recording financial statements. This is especially important for subscription businesses, who accept recurring advance payments in exchange for the ongoing delivery of goods or services.
Understanding Unearned Revenue
In a conventional sale, a customer will make a payment and receive goods or services either instantly or after a short delay. This makes revenue recognition straightforward, as there’s no unearned revenue to factor into that accounting period.
In other business settings, unearned income makes bookkeeping more complicated. If a company still owes goods or services to the customer after receiving payment, it must be recorded as a liability on the company’s balance sheet until it can be recognized as earned revenue.
Examples of unearned revenue include:
- Membership fees i.e. gyms, clubs, classes.
- Insurance policies or service contracts where payment is taken upfront, as this represents a long-term liability.
- Legal retainers.
- Magazine subscriptions offered as monthly or annual subscriptions.
- Tickets purchased ahead of travel or events, as the revenue cannot be recognized until the actual offering has been redeemed i.e. a concert or a flight.
- Advance rent payments.
Unearned Revenue in Subscription Businesses
Unearned revenue plays a significant role in subscription-based businesses. Consequently, they are one of the most commonly cited unearned revenue examples in the SaaS space.
In a conventional subscription model, the customer will pay for access to a particular product or service over a set period of time. For the business, a subscription entails the ongoing delivery of goods and services for the entirety of the term. Common subscription types include software as a service (SaaS) subscriptions, streaming services, and subscription boxes of physical goods.
When a customer pays for a subscription in advance, the company has to record this as deferred income. As the subscription business fulfills its obligations, the unearned revenue can be gradually recognized over time as earned revenue on the income statement.
How Should You Account for Unearned Revenue to Stay Compliant?
The five-step model in ASC 606 takes businesses through the process of creating the appropriate schedule for recognizing revenue:
1. Identify the contract with the customer
Under ASC 606, a contract refers to any agreement between two parties that is verbal, written, or implied. It must promise the delivery of goods or services by the business, and the promise of payment by the customer.
2. Identify the performance obligation
The performance obligation is a business’s promise to transfer a good or service to the customer. These obligations must be defined and recognized individually if the transfer of goods or services is standalone from the remaining performance obligations in the contract.
3. Determine the transaction price
The transaction price includes all variable considerations such as rebates, contract modifications, price concessions, or customer incentives.
4. Allocate the transaction price
Subscription-based businesses have continuous performance obligations, meaning they need to allocate the transaction price over time to recognize revenue as separate obligations are fulfilled.
5. Recognize revenue
The timing of revenue recognition will depend on when each performance obligation is fulfilled For a subscription business, revenue is gradually recognized from the point that a subscription has begun until the term is completed.
How Should Businesses Recognize Unearned Revenue?
Recognizing unearned revenue as a SaaS or subscription business rests on the revenue recognition principle in accrual accounting. This principle states that revenue can only be recognized when payment has been received and all products/services owed to the customer are fully redeemed. This differs from cash accounting, when revenue is recognized as soon as goods or services are paid for. Accounting Standards Codification 606, commonly known as ASC 606, sets out clear steps for how and when subscription businesses should recognize unearned revenue and debit it to their cash account.
Benefits of Unearned Revenue for Subscription Businesses
Financial stability and cash flow management
Because customers pay for subscriptions on a recurring basis, most subscription businesses have predictable cash flow. This helps them to cover operating expenses and invest in initiatives that help to grow their business, such as promotions, marketing strategies, and customer experience strategies. Because unearned revenue is received upfront ahead of the product or service being fully redeemed, businesses have a decent financial buffer—so long as they understand their current liability.
Customer commitment and business forecasting
Many subscription offers will lock customers in for multiple subscription cycles in exchange for a more favorable rate, such as quarterly, six-monthly, or annual plans. These longer-term subscriptions provide businesses with a stable source of unearned revenue that helps them to make more informed financial decisions.
Moreover, these longer subscription cycles and recurring payments help to foster stronger loyalty and retention over time, especially for SaaS products, where subscribers grow accustomed to having access to certain capabilities.
Regulatory compliance and financial reporting
Because service revenue needs to be kept separate from earned revenue until the point it can be recognized, there is a robust set of accounting principles for business owners to follow that ensures unearned revenue is recorded correctly.
The International Financial Reporting Standards (IFRS) and Generally Accepted Accounting Principles (GAAP) require subscription businesses to recognize revenue based on when goods or services are delivered, rather than when payment is accepted. Ensuring that your business is accounting for unearned revenue correctly ensures that your financial statements accurately reflect actual financial performance. This helps to build trust among key stakeholders such as management, investors, and financial institutions.
Challenges Associated with Unearned Revenue
Managing customer expectations and satisfaction
Just like any business, subscription companies are duty-bound to provide goods or services to their customers and maintain a high standard of communication throughout the subscription period. They must comply with all applicable laws and regulations surrounding pricing, cancellation policies, and refunds.
Managing unearned revenue can complicate these efforts, leading to customer dissatisfaction and churn. For example, if a customer chooses to cancel their subscription and have the reminder refunded, this can disrupt unearned revenue projections. This may result in delays in refunding that money—especially if it has a big impact on working capital.
Legal and regulatory implications
There are strict accounting standards in place to manage unearned revenue and revenue recognition for large and small businesses. Non-compliance with accounting standards such as IFRS or GAAP can result in significant financial penalties—not to mention a loss of trust with customers and stakeholders. So, it’s essential you’re using the right software and that legal and accounting teams are up to speed on their obligations.
Revenue recognition challenges
Correctly recognizing revenue as a subscription business can be very complex. The timing of the revenue recognition will vary depending on the length of the subscription period, the product itself, and whether any discounts or rebates are in effect that require adjusting entry of revenue. For financial accounting purposes, businesses must establish a clear schedule for recognizing revenue and recording both their long-term and short-term liabilities. If you have multiple subscription products and periods under your business, tracking this accurately is essential to avoid errors in your unearned revenue account.
Managing Unearned Revenue Effectively
Implement best practices for managing cash flows from unearned revenue
It’s important to constantly monitor unearned revenue and your accounts receivable to understand your current level of liability and whether your revenue recognition schedules are still compliant with accounting standards. Any changes you implement to subscription terms or payment practices may affect revenue recognition, so this needs to be carefully considered and planned for.
Use tools and software that can assist with unearned revenue management
An Excel spreadsheet won’t get you far in managing unearned revenue. Accounting software that offers double-entry bookkeeping, tracking unearned revenue journal entries, and managing cash and liability accounts is essential to stay compliant with revenue recognition rules.
A robust subscription management platform like Stax is capable of managing not only recurring billing, invoicing, and CRM, but also automating the entire revenue recognition process so you can focus on building your business.
Consider strategies to mitigate risks associated with unearned revenue
Subscription models carry inherent risks in the form of churn, as profitability is gained from retaining customers through numerous subscription cycles. A sudden uptick in churn can cause considerable disruptions to cash flow, so your business must have strong reserves to get through any unstable periods without sacrificing the quality of your service. Consider how your business can best respond to customer churn or slowdowns in new subscriptions, such as plan upgrades, discounts to stay subscribed, or referral offers.
Final Words
Unearned revenue plays a central role in accounting for subscription businesses. Revenue earned from subscriptions must be recognized gradually over time as the subscription progresses, rather than the outset. This results in complex accounting of short-term and long-term liabilities, as well as correctly following revenue recognition schedules as set out in ASC 606.
With a growing number of SaaS companies shifting to subscription offerings or diversifying subscriptions to bolster revenue, accurate revenue recognition and reporting of unearned revenue will only grow more important over time. Using a system like Stax to manage subscription billing and automated revenue recognition frees up time for you to focus on growing your business and improving the customer experience—not worrying about accounts receivable.
FAQs About Unearned Revenue
Q: What is unearned revenue?
Unearned revenue, also known as deferred revenue, is money received by a business for goods or services yet to be delivered or performed. It is recorded as a liability on the company’s balance sheet because it represents an obligation to provide products or services in the future.
Q: What is an example of unearned revenue?
An example of unearned revenue is a subscription-based service, like a SaaS software subscription. The company receives payment upfront for a year’s worth of services, but it has not yet delivered that value to the customer. Until the company’s subscription is fully used up, the revenue is considered unearned.
Q: How do you record unearned revenue?
Unearned revenue is recorded as a liability on the balance sheet when the payment is received. The entry involves debiting the cash account and crediting the unearned revenue account.
Q: How do you adjust for unearned revenue?
Adjusting for unearned revenue involves moving the amount from the unearned revenue account to the revenue account as the services are performed or the goods are delivered. This adjustment is typically done periodically, such as monthly or quarterly, depending on the terms of the agreement.
Q: When do you recognize unearned revenue?
Unearned revenue is recognized as revenue when the goods or services are delivered or performed. The timing of recognition depends on the terms of the agreement with the customer and the delivery of the promised goods or services.
Q: What is another term for unearned revenue?
Another term for unearned revenue is “deferred revenue.”
Q: Is unearned revenue taxable?
Unearned revenue is not taxable when it is initially received because it is considered a liability. However, it becomes taxable income once the revenue is earned, meaning the goods or services have been delivered or performed. The timing of the taxability can vary based on local tax regulations and accounting practices.
