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Unearned revenue is a vital concept for businesses of all sizes. After all, it can have a substantial impact on a company’s financial health and growth potential. In fact, Amazon’s unearned revenue has grown from $1400 million to $2900 million in the last 5 years.
But what exactly is unearned revenue? And how can it benefit a business? In this blog, we’ll explore unearned revenue in detail, including its definition, benefits, and risks. Let’s start!
Unearned revenue is the money or advance payment that a company gets before providing a service. Companies list unearned revenue as a liability on their balance sheet. The unearned revenue usually has to be fulfilled within a year.
However, sometimes customers may pay for services the business has to provide for many years. In such cases, part of that payment will be listed as unearned revenue after a year under the long-term liability section of the balance sheet.
For example, for the two-day shipping service, Amazon Prime members normally pay $99 upfront for the entire year. Amazon gets the money right away and records it on its balance sheet, but it spreads the $99 in revenue over the course of the membership’s first year. So, it only generates $8.25 in monthly revenue for each Prime member. Amazon keeps the remaining funds collected for Prime in the balance of unearned revenue.
Unearned revenue is not the same as accrued revenue. The latter is when a business has earned money. But it hasn’t received it yet. For example, suppose you did work for a client. But the client has not paid you yet. That money is accrued revenue.
Recognizing unearned revenue allows businesses to accurately report their financial performance. It helps them avoid overstating their revenue and profitability. Otherwise, overstating can lead to incorrect financial reporting and poor decision-making.
Moreover, when a business recognizes unearned revenue, it facilitates effective cash flow management. This is because unearned revenue allows the business to spread revenue over the period during which it delivers goods or services. As a result, the business avoids cash flow issues that may arise from receiving large payments upfront.
Unearned income can aid in cash flow, financial stability, and investment opportunities. Besides, it can benefit a business in several other ways too:
When a business receives payment in advance for goods or services it hasn’t provided, it can use that money to manage its expenses and invest in growth opportunities.
For example, a software company receives payment in advance for a one-year subscription to its service. This provides it with upfront cash. And the company can use it to pay its employees. It can also invest in research and development. Or, it can expand its marketing efforts.
Another example is a construction company. Suppose it receives a deposit from a client before starting a project. It can use the money to purchase materials and pay subcontractors. Also, it can cover other project-related expenses.
In both cases, unearned revenue gives a cash flow advantage. That can help businesses improve their financial position and pursue growth opportunities.
Financial stability is an essential factor for any business. Unearned revenue can provide a cushion to businesses. So, it can make a company financially stable during difficult times.
For instance, a fitness center sells annual gym memberships to its customers. It collects the membership fee upfront. But it allows customers to use the gym facilities throughout the year.
In this case, unearned revenue will provide financial stability to the gym even if the number of customers decreases. The gym can use this revenue to cover expenses until the customers return.
Unearned revenue gives businesses a better idea of how much they can expect to receive. As a result, it can help them create budgets and make financial plans. So it can help them with planning and decision-making.
For example, a company receives prepayments for a subscription service. It can use this information to plan for the necessary resources to deliver the service.
Also, if a company receives prepayments for a product not yet released, it can use this information to plan for the necessary inventory and production capacity.
A clearer picture of the future revenue stream can help businesses make wise decisions about investments, expansion, and hiring.
Unearned revenue shows that money is coming in, even if the business has not provided goods or services yet. So, it can make a business look more attractive to investors.
For example, a business receives payments for a year-long software subscription upfront. It can show a significant amount of unearned revenue. This revenue can show investors that the company has a consistent revenue stream. Also, it can help with financial planning.
With the money coming in, the business can pay back the loan. So, unearned revenue can help secure loans.
For example, a construction company receives payments upfront for a project. It can use that unearned revenue to secure a loan for materials or equipment needed for the project.
While unearned revenue can be beneficial, there are some risks to be aware of:
Suppose a business is unable to provide the promised goods or services. Then, customers may become dissatisfied. Also, they may never return.
If a business has taken payment for goods or services it cannot deliver, it may face legal action. Or it may damage its reputation.
Poor management of unearned revenue can lead to inaccurate financial reporting. Further, it can lead to legal and financial consequences for the business.
Unearned revenue is a vital concept. And thus, businesses need to understand it. As a result, it can help with cash flow, financial stability, and business planning.
But businesses also need to be aware of the risks coming with unearned revenue. These include customer retention, contractual obligations, and mismanagement.
If businesses manage their unearned revenue in a proper way, they can maximize its benefits and avoid potential pitfalls.
If you have questions about accounting, you can seek guidance from GJM & Co. Our experienced professionals can assist you.
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