Sometimes referred to as deferred revenue, unearned revenue is compensation that is received before the recipient actually delivers the good or service promised to the buyer. There are many situations in which this form of revenue is generated, including payments on a lease contract. In general, any unearned income received is considered a liability from an accounting standpoint, until the recipient provides the purchased goods or services to the buyer. At that point, the revenue is no longer unearned, and is counted as earned income.
While many people think of a liability as being a debt that is owed as the result of a purchase, the term can also apply to any funds that are collected prior to the recipient providing the goods or services ordered by the buyer. This type of unearned or deferred revenue must be accounted for in the company’s billing records. Often, the process involves showing the unearned revenue on the customer account as an opening balance, then subtracting charges from that balance until all promised products have been delivered to the customer.
There are many situations where some sort of prepayment is required in order to obtain goods or services. One common example has to do with renting or leasing a house or apartment. It is not unusual for landlords to require that the tenant pay the first and last month of the lease in advance, since this helps to reduce the risk that the landlord is assuming by renting to the tenant. After the first month of residence, a portion of that unearned revenue is no longer considered a liability, but income. Once the final month of the lease has passed, the remainder of the unearned revenue is considered earned, and the deal between the two parties is considered fulfilled.
It is not unusual for businesses that offer products such as telecommunication services, property management, or building and construction services to actively seek unearned revenue by offering buyers some sort of inventive to prepay their contracts. For example, a business may offer a percentage discount on each unit of a given product that is ordered, if the consumer will pay for all the ordered units in advance. The benefit to the business is that the revenue can be used today to manage the debt of the business, or as a means of raising capital that can be utilized in an expansion project. As each billing period passes, those advance payments are converted into assets and are no longer listed in the accounting books as liabilities. Ideally, the business has made wise use of those funds and strengthened its ability to continue providing goods and services to its clientele.