Unearned revenue might seem like a contradiction in terms. If a customer gives you money for a product or service, haven’t you earned the revenue?
If you run a business where your customers pay you in advance for products or services you haven’t yet delivered, then you must understand unearned revenue. In particular, you need to be familiar with how unearned revenue is handled in your business accounting, how it affects your taxes, and how to manage the cash sitting in your bank account—cash which isn’t technically yours yet.
What Is Unearned Revenue?
Unearned revenue can be defined in a single word: prepayment.
Whether it’s a retainer, a deposit, or a full year’s worth of services purchased in advance, unearned revenue is simply prepayment for products or services not yet delivered to the customer.
Industries Where Unearned Revenue Is Common
Many businesses have unearned revenue, though not every business accounts for it properly (more on that in a bit). Some businesses where unearned revenue is common include:
- Professional services firms (accountants, lawyers, etc.) that require a retainer for services before work commences.
- Property management companies that require deposits (pet deposits, first and last month’s rent, etc.) that will be refunded at the end of the lease period if certain parameters are met.
- Insurance companies (think of the six-month premium you pay for automobile insurance).
- Tour companies that require a deposit months before a trip takes place.
- Some contractors, though retainage—which is the opposite of unearned revenue—is more common in this industry.
This is by no means a comprehensive list. As more businesses move toward pay-in-advance or subscription/membership models, unearned revenue is becoming increasingly common. Unfortunately, not everyone knows how to properly account for or manage unearned revenue, and this can spell big trouble for your business.
Is Unearned Revenue a Liability?
Whenever a customer pays you for products or services you have not yet delivered, it creates a liability for your business. Conversely, these prepayments to you are assets on your customers’ books, commonly classified as prepaid expenses or deposits.
Unearned revenue—and prepaid expenses/deposits—are real-life applications of the matching principle. The matching principle is a generally accepted accounting principle (GAAP) that states revenue should be recorded in the period in which it is earned and expenses should be recorded in the period when they are incurred—regardless of when money exchanges hands. This is an accrual-basis accounting concept you might be tempted to ignore if you keep cash-basis books for tax purposes. However, doing so can put your business at risk in various ways.
The examples in the following section will help you understand the benefits of properly managing unearned revenue, as well as the risks of mismanaging it.
Unearned Revenue Example
Let’s say you run a small group tour company. In order to secure the best travel dates and the lowest rates, you must book your tours months—and in some cases a full year—ahead of time. And these bookings aren’t free: The airlines want the fares upon booking, hotels require deposits, and travel visas can run several hundred dollars per traveler.
There’s also some risk. Often, these lower rates are accompanied by no refund, or only partial-refund, policies.
This means you must require deposits, sometimes totaling thousands of dollars each, from your travelers. These deposits are typically at least partially refundable if the traveler must cancel the trip.
Back in November 2019, you rolled out a European tour scheduled for June 2020, and it immediately sold out. Twenty customers paid deposits of $5,000 each for the trip, of which $3,000 was refundable if the customer canceled prior to 30 days before the start of the trip.
In your bookkeeping, the following transaction took place:
Checking $100,000 (20 travelers x $5,000 = $100,000)
Unearned Revenue: Refundable Deposits $60,000
Travel Income $40,000
You only recorded the non-refundable $40,000 ($2,000 for each of the 20 travelers) as income. The other $60,000 (the refundable portion of the deposits) went onto your balance sheet as a liability. And only the $40,000 non-refundable portion appeared on your profit and loss statement. (Note: Under true accrual accounting, the non-refundable portion of the deposit wouldn’t appear on your P&L immediately, either. We’re simplifying this to streamline the example as it pertains to unearned revenue.)
You immediately booked airfare and made hotel deposits (both non-refundable) totaling $35,000.
Cost of Sales: Travel Expenses $35,000
If you were to run a profit and loss statement just for this trip at this point, you would see a gross profit of $5,000.
Travel Income ($40,000) – Travel Expenses: Cost of Sales ($35,000) = $5,000 Gross Profit
You could have recorded the entire $100,000 you received for this trip in 2019 as income. That $100,000 would have been offset by the $35,000 you paid for airfare and hotel deposits, and you would have been taxed on $65,000 ($100,000 – $35,000 in expenses) when you had your tax return prepared in February 2020.
However, by recording your unearned revenue properly, you were only taxed on $5,000 ($40,000 in non-refundable deposits you recorded as income – $35,000 in expenses). To read the determination that set this precedent, read the IRS’ explanation. Also, always check with your tax professional regarding your unique tax situation.
In March 2020, your customers started canceling their travel reservations. By the end of April—well before the deadline to cancel the trip and receive a partial refund—all 20 customers had canceled. You had to refund $60,000 to your customers.
Here’s what happened in the bookkeeping and in your bank account:
Unearned Revenue: Refundable Deposits $60,000 (ending balance $0)
Checking $60,000 (ending balance $5,000)
Remember, you took in $100,000, paid out $35,000 in airfare and hotel deposits, and then had to refund $60,000 to your customers. This left you with $5,000 in your checking account.
Fortunately, you had not paid taxes on the full $100,000. Had that happened, your bank account balance would have been dangerously low—perhaps even negative—after making the refunds.
If you receive a sizable amount of unearned revenue you might have to refund—no matter how slim the chance—we recommend putting that unearned revenue amount into a separate bank account. This will ensure you can refund the money if needed. It will also help you keep your spending under control because you won’t be tempted by a large balance when you see your checking account, meaning you will also be able to cover your tax liability when the revenue is recognized.
As the economy increasingly shifts to a pay-in-advance or subscription-based model, more businesses are going to need to know how to properly account for unearned revenue. Anytime you receive money for products or services your business has not yet delivered on—meaning there is a chance that you may have to refund the money—a liability is created for your business.
As our extended example showed, properly accounting for and managing your unearned revenue not only helps you see your business’s true profitability, it can also save you from cash flow issues should you have to refund a significant amount of money. And although you will owe taxes on all earned revenue eventually, only paying taxes on unrestricted revenue can further prevent cash flow issues should the worst happen in your business.
This one, extremely-simplified, example should not be taken as legal or tax advice. If your business has significant unearned revenue, talk with your accountant to determine the best way to account for the revenue. Make sure your accountant understands you are interested in getting good management reports in addition to providing them with books they can use to prepare your business’s tax returns. Your accountant can then work with your bookkeeper to set up the proper accounting system for your unearned revenue liabilities.