Is Unearned Revenue a Liability?
This is a common question not only among accounting students, but also business owners.
First, the word “Revenue” means an income.
Secondly, it is cash that has been received.
The work has not yet been done, meaning the income is not earned.
So, is this a liability?
There is a lot of reasoning that can happen around this one.
And the answer is right there in the reasoning, only that it may not be very clear.
Unearned revenue, also known as deferred revenue, is income received by a business for work not yet done. It is an advance payment for work expected to be done at a later date or time.
If your business sells goods, then you may get paid for the expected goods even before delivery.
If you sell services, you may get payment for it pending the actual service delivery.
Although the money has been received, this transaction is actually a liability.
You are now expected to do something in order to “earn” the money received.
In other words, you are now indebted to the one who paid you. And if you are indebted, then you have a liability. This is money you have to “pay back” through the completion of work.
The presence of cash is what often causes confusion in the business.
As your cash flow improves and you are able to do more, you tend to only focus on the money and the possibilities.
Meanwhile, you forget the accompanying debt you have incurred.
Accrued Revenue vs. Unearned (Deferred) Revenue
There are two different types of revenue coming into the business.
These are largely what define the type of accounting done by businesses.
The first type of revenue is called accrued revenue.
This is revenue which is expected to come into the business. Most B2B transactions involve this kind of revenue.
The supplier provides what has been ordered then awaits payment which is to come at a later date.
For this to work however, there has to be a prior agreement.
This is also called credit trading: you sell now and get paid later.
Some everyday examples of accrued revenues are:
- Employees work then they get paid at the end of the month
- You shop using a credit card then pay at the end of the month
- Being billed for a utility after a month’s use
Unearned revenue is just the opposite of this.
Instead of working then getting paid, you get paid first, then work for the money received. In this case, the one receiving your services has no obligation towards you.
All they need to do is have an active expectation.
On the other hand, by receiving the payment in advance, you are legally bound to provide the promised goods or services.
Therefore, accrued revenue is the revenue earned (worked for) but not yet received.
Unearned revenue on the other hand is that which has been received but not yet earned (worked for).
REAL-LIFE EXAMPLES OF UNEARNED REVENUE
The examples of accrued revenue may sound very realistic and normal.
But unearned revenue is equally normal and is experienced on an everyday basis.
The moment you look more keenly, you will recognize them.
Here are some examples.
Airline Ticket Booking
Have you ever asked a pilot, or the airline staff at the airport, to let you travel before buying the ticket?
Better still, can you imagine giving the condition that you will only pay the full ticket cost once you arrive at your destination safely?
Sounds crazy of course. But have you every given it some thought? You actually pay and wait for an aircraft.
You board it and hope to get to your destination safely.
What happens when there are flight delays?
You complain. But that doesn’t change the mode of operation. You just pay and hope they deliver.
The airline industry works through the unearned revenue model.
For any service to be provided, you have to pay in advance.
Moreover, you may need to pay several days in advance since there are limited spaces.
Picture your favorite magazine delivered at your doorstep or mailbox every month. The person making the delivery never waits for your payment.
He just drops it and leaves. If you were to meet him, all you can expect is a greeting.
You are so used to it that you don’t think about it. You trusted the publishing company enough to pay them for a full year’s worth of magazine content.
And now you have to wait for them to deliver it.
For them, they obviously delighted in getting your payment as that is an income for them.
From it however, is an obligation to always deliver on great and enjoyable content that you will love.
And if you have labeled the magazine a favorite and have an active subscription running, then they won you over.
What if they started producing lackluster content? You might write them a complaint letter. Or if you go the social media way, you might comment on their Facebook page. Or give a negative review on their twitter handle.
Because you are entitled to something.
By virtue of having made an advance payment, you are entitled to receiving better than what they have given.
This is exactly how the unearned revenue becomes a liability. The recipient has a debt to pay.
Remember when the insurance agent gave you all the bad scenarios which could become a reality in your life?
It could be an accident which leaves you paralyzed and in need of urgent but expensive surgery. It could be your new car, which is the talk of the office, getting stolen.
Maybe your house being broken into. Or your children not advancing to university due to lack of fees.
None of these scenarios is anything you would want to experience.
The good thing is that he had a solution for you.
He promised that he could take care of all those fears he had raised inside you.
That he could guarantee your peace of mind. He would see to it that you never thought about your son’s education because he would take care of.
He would pay for it—if you gave him the money. This money is referred to as the insurance premium.
You were going to give him the money even before your son finished high school. This was a guarantee and good idea for you.
But the fact is that you paid in advance for a service you only hoped to receive several years to come.
HOW TO RECOGNIZE REVENUE
Understanding the challenge caused by the different and complex scenarios in business, the Securities and Exchange Commission (SEC) developed criteria top help recognize revenue.
There are four different aspects to be considered. If the transaction checks all these boxes, then what is received is revenue.
Otherwise, the earning from it will have to be deferred to a later date when it can pass the test. This makes the transaction a liability.
The criteria is as below:
- Collection is assured – this refers to the probability of collecting payment from the transaction done. If you have sealed a deal but are unsure of whether you will receive payment from it, don’t count it as a sale. Only do so once you get the payment.
- Delivery has occurred or services rendered – anytime a transaction takes place, there must be a change of ownership of the goods. It is only after the buyer has assumed ownership and the risks involved in the ownership that the transaction should be counted as a sale.
- Persuasive evidence of an arrangement – for a sale to be recognized, the SEC requires that there has to be some evidence of the same. For example, goods transferred to a retailer for the purposes of display cannot be said to be a sale.
Also, anytime goods leave your premises but can be sent back after their purpose is fulfilled, e.g. demonstration, then that is not a sale.
- The price can be determined – price determination is all about guaranteeing that the sale has taken place. This is in view of the possibility of order cancellation. When there is a cancellation, it is considered that the price for that product could not be determine.
In essence, no price has been paid for the product.
The presence of cancellations points to the possibility that the product or service returned had been given for demonstration purposes.
This then is not a sale and proceeds from it should not be counted as revenue.
After the expiry of the return period, goods can be recognized as sold and revenue received from the sale.
ADVANTAGES OF UNEARNED REVENUE
There are benefits which are experienced when you receive unearned revenue.
These are mostly revolving around the availability of cash for your business needs.
With increased cash flow, there is literally very little, if any, that you cannot do.
Let’s look at some of the advantages of these earnings.
Easily Facilitate Work Paid For
The payment you have received is for work not yet done. In most cases, the work you are required to do has some costs involved. For example, you may be required to get some supplies.
And unlike your obligation to the customer, your supplier has no obligation towards you.
This can negatively affect your performance and even make it difficult to complete the work. This is in the backdrop of the pressure you already have as you are obligated to deliver.
When you get paid for work not yet done, you are able to budget for the work and spend money on what needs to be done.
This can make the work easy. You will be readily equipped to do the job and successfully complete it.
Improved Cash Flow
The availability of money provides the much-needed liquidity which any business stands to benefit from.
Other than the ability to focus the received cash on the task at hand, you can also use the money for other business operations.
With improved cash flow, you can buy more inventory, hire more temporary staff, put up a marketing campaign etc. The list of things can only be limited by your imagination and business needs.
Depending on the amount received, you can even launch an expansion program or increase the capacity of your research and development department.
Whatever you do with the money, it is a welcome blessing. It is one which could have come at a later date but has been made available now.
Motivation for Work
Ever heard the saying that “You shall eat the fruit of your labor?”
Well, how would you love to have a taste of the fruit even before the labor?
The money received in advance is an incentive to work on the job. You should get motivated to work.
The customer has seen it good to pay before receiving the product. This should excite you as you get to understand that your brand is trusted.
If a customer can trust you that much, then he is already, or is soon going to be, a loyal customer. All you have to do is ensure you don’t disappoint him.
Just as being paid after putting in the hard work feels good, you have the opportunity to run with this payment and enjoy doing the work.
Reduced Bad Debts
There is no worse thing in business than not getting paid for the products you sold or services you offered.
Not only does this demoralize you, but it also puts you at risk of closing down. If enough customers fail to pay and pay on time, you can be on your way out.
Doing business under credit terms is tricky.
You simply have to trust that the customer will honor his pledge of paying you according to your agreement with him.
The last thing you want to record in your books is bad debt.
Bad debt is the debt which you have completely no hope in recovering.
This is the debt you have followed up on and no longer have any assurance that you will ever receive it.
In its strictest sense, you have a bad debt when the person owing you money is completely unable to pay. This may be the result of insolvency.
When you get paid in advance, you get an assurance that the order in question will not lead to a bad debt.
Not only are you guaranteed of payment, but have already received it.
You therefore have an assurance that your business will be progressing well and can meet its obligations.
DISADVANTAGES OF UNEARNED REVENUE
Anything that goes up must eventually come down.
So anything which has advantages must also have disadvantages.
Unearned revenue can make you happy that you have received money in advance.
But there are some serious dangers in handling money you have not yet officially earned.
Here are some of them.
Can Create the Wrong Impression on Your Financial Status
The most immediate reaction to money received in advance is a feeling of joy.
Can you imagine that someone trusts you enough to pay even without seeing the product?
You must be having a strong brand. Yet you are probably new in the industry.
This situation is dangerous because it can lead to a false sense of security.
You can easily think that your business is doing well because of all the money coming in.
This is especially so if you receive many such payments.
As your vision gets dulled, you may start making wrong decisions based on the wrong impression of your financial status.
If you make your financial reports after a full year, then it means you may have to wait till the year is gone before finding out the true financial standing of your business.
If this has been happening throughout your financial year, then there might be too much damage.
And the cost of fixing that may be very high.
Danger of Improper Use of the Money
You have made a presentation to a client. He liked it, placed an order and paid in advance. The money is to facilitate product or service delivery.
But is there a guarantee that this is what will happen?
There can never be a guarantee for this.
With cash at hand, many needs can suddenly arise. Money is the solution to many problems and when money is available, you tend to feel in control.
This feeling may lead you to putting the money to wrong use. You may not realize it at first.
It may be a small undertaking. It may be a small recurring debt. Or you may decide to reward the marketing team by buying them lunch.
That seemingly small expense will have significant repercussions on the business.
If the money is put to the wrong use, the action will come back to haunt you in the future.
You may have overall profits because it was a great year for you but you could have had better.
Unwarranted action could cause a decline in profits. It can mean postponing the opening of the planned new branch in the neighboring city.
Can Cause Complacency at Work
When you get paid before doing the job, you can easily become disinterested in performing the task. Or you can perform the task but not to the required levels of quality.
This will be because you have nothing pushing you to do a good job.
If you have already been paid, you may start developing some form of pride. You may trust yourself too much and end up providing low-quality work.
If the customer notices it, he will start questioning his decision to buy from you. Whether he mentions it to you or not, the fact is that he may decide to shift allegiance.
Looking at both sides of the argument, is there any real benefit in receiving unearned revenue?
Consider your unique situation and make the best decision.
You may not refuse advance payment but you definitely need to invest in proper accounting and accountability.
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