Large and small businesses have one thing in common; the need to track and recognize their revenue accurately and at the appropriate time. Why? Because if you can’t keep track of your revenue, it’s impossible to make data-driven decisions about your business.
That being said, not all revenues are created equal. Just because money hits your bank account, it doesn’t mean you can automatically count it towards your bottom line.
Depending on your industry and business model, you may need to satisfy a few conditions before you can consider funds as earned revenue. In certain instances, businesses need to classify revenue as unearned in order to comply with accepted accounting standards.
In this post, we’ll tackle the ins and outs of unearned revenue and how to track it.
Why Revenue Tracking is Important
Before diving into the concept of unearned revenue, it’s worth taking a step back and discussing why businesses need good revenue tracking practices.
Accurate revenue tracking and recognition assist you with other areas, such as:
Identifying different types of revenue
Most businesses will boast a roster of goods and services—all of which need to be tracked to build a picture of where your revenue is becoming from.
Knowing which products are performing well and which might be running at a loss is crucial to ensuring profitability. Moreover, seasonal fluctuations in the demand for different products and services may result in peaks and troughs in your need for labor, storage, or marketing. Being able to track these with accuracy ensures that you don’t end up paying over the odds to keep your business running.
Understanding your cashflow
Understanding the natural ebb and flow of your revenue ensures your business can make large investments, apply for additional capital, or reduce payable debts. This can only be done by carefully tracking your revenue and determining when your working capital is at the right level to take these steps.
Recognizing revenue at the right time
It’s important to note that not all revenue can be recognized equally. While some revenue can be recognized the moment a transaction takes place, the recognition of other types of revenue must be deferred until a later date.
Knowing when and how to recognize unearned revenue can be a tricky situation for businesses to navigate. That‘s why we’ve put together this guide to assist you with managing unearned revenue—and how Stax Bill can help!
What is Unearned Revenue?
Unearned revenue, also referred to as deferred revenue, is when businesses receive payment from customers for goods or services they haven’t yet delivered. In effect, unearned revenue is a form of prepayment made by the customer. For this reason, it cannot be fully recognized revenue during that accounting period until such a time where the good or service is considered fully completed.
Unearned revenue leaves goods or services from financial arrangements outstanding, so it’s considered a liability on financial statements. This is because there’s the risk that a company may fail to deliver on the goods or services promised to the customer. If this happens, the business would owe the customer for what hasn’t been delivered. By waiting until after the goods or services are fulfilled, businesses can recognize revenue appropriately.
Why is it Important to Account for Unearned Revenue?
Unearned revenue can feel like something of a misnomer. When a customer makes a purchase, it‘s easy to assume the total sale value should be counted as revenue. These journal entries of advance payments are great for cash flow. But in practice, revenue recognition is not quite that simple.
Under both ASC 606 and Generally Accepted Accounting Principles (GAAP), unearned revenue must be recognized at a later date on the company’s balance sheet. This is because recognizing both earned and unearned revenue equally would result in inflated profits.
According to GAAP, revenue can only be recognized when the following conditions are met:
- Clear evidence of a financial arrangement
- Completion of product or service delivery
- Price to the buyer is fixed or measurable
- Funds are reasonably collectible
Subscription-based businesses in particular are much more vulnerable to unearned revenue accounting rules, due to how service revenue is accrued over time. The U.S. Securities and Exchange Commission (SEC) also states that business owners must be able to project when deferred income will be fully realized. This puts the burden on businesses to ensure that they are accurately calculating both short-term and long-term liability on their balance sheets.
Examples of Unearned Revenue
Let’s say that a customer signs up for an annual subscription to a software product for $99. Although they’re paying for the entire twelve months upfront, they don’t receive the service in one go.
Because the business still owes delivery of the entire service to the customer, any prepaid revenue must be recognized as a short-term liability on the balance sheet until the entirety of the customer’s subscription has been realized—i.e. at the end of the twelve months.
In practice, this requires the business to practice double-entry bookkeeping. They need to deduct a monthly figure of $8.25 from that unearned revenue account as debit to the cash account, while the same amount is credited as revenue. This adjusting entry is repeated until the subscription ends, at which point the entirety of the subscription can be recognized as revenue.
How Should Businesses Recognize Unearned Revenue?
Software subscriptions are far from the only offering where businesses need to follow accrual accounting principles. Any offering where the customer is owed a product or service after payment, such as airline tickets, insurance, advance rent payments, and legal retainers must be classified as unearned income until the point where they are fully redeemed.
As you can see, deferred revenue requires a fair bit of juggling on your income statement to make sure that your current liabilities are up to date. Multiply this one subscription by hundreds, and it’s not hard to see why unearned revenue can be overwhelming for businesses to manage.
How Should You Account for Unearned Revenue to Stay Compliant?
ASC 606 is the new revenue recognition standard that both private and public companies must apply when recognizing unearned revenue. This was introduced to simplify financial accounting and create more consistency in revenue recognition between different industries.
The core accounting principle of ASC 606 is that unearned revenue can be recognized when the contractual obligation of a sale is met, rather than when the initial payment is made.
According to ASC 606, businesses must follow the below steps to recognize their earned and unearned revenue:
1. Identify the contract with the customer
ASC 606 classifies a contract refers to a visual, written, or implied agreement between two parties that creates enforceable rights and obligations.
2. Identify the performance obligation
Performance obligations refer to the promised transfer of goods or services to the customer by the business, according to the terms in the contract.
3. Determine the transaction price
The transaction price should include any relevant variables such as rebates, contract modifications, discounts, price concessions, or promotions.
4. Allocate the transaction price
Subscription-based businesses have ongoing performance obligations, as they receive recurring sources of revenue from customers. This is why they need to consistently allocate the transaction price as revenue over time as a customer’s subscription progresses.
5. Recognize revenue
Businesses need to evaluate when is the right time to recognize revenue according to when they fulfill their performance obligations. This normally happens when control of the good or service is transferred to the customer. For subscription-based companies, revenue recognition must happen gradually as the customer receives each portion of the service they’ve paid for.
Final Words
Subscription revenue is vulnerable to sudden changes, such as customers halting or upgrading their subscriptions, redeeming free credits, or switching to a different plan different. Constant unearned revenue journal entries and a multitude of liability accounts mean it’s almost impossible to manage revenue recognition manually.
With the Stax Bill system, businesses no longer have to worry about their accounts receivable or liabilities. Revenue recognition is handled automatically, thanks to Stax Bill’s ability to manage multiple subscription options and pricing plans. The dual-entry accounting system ensures that every upgrade or adjustment made by your customers is captured and processed either as earned or unearned revenue—no manual bookkeeping required!
Want to make managing and tracking unearned revenue a breeze? Get in touch today to find out how we can take the pain out of subscription management.
