Unearned revenue: Definition and how to record it

Unearned revenue is money received by a business for goods or services that have not yet been delivered. It is classified as a liability on the balance sheet because the company still owes something to the customer. Once the product is provided or the service is completed, the revenue is recognized as earned income.

This type of revenue is common in subscription-based businesses, SaaS companies, insurance providers, and prepaid service contracts. Businesses must follow proper financial accounting rules to record and recognize it correctly. Failing to do so can lead to financial misstatements, tax issues, and compliance risks.

Why do businesses receive unearned revenue?

Businesses accept unearned revenue because upfront payments provide financial stability and reduce risk. Customers often pay in advance for products or services to secure availability, lock in pricing, or meet contract terms. This allows companies to plan ahead, allocate resources, and operate without relying on credit or uncertain future sales.

Prepayments also help businesses manage cash flow. Companies with high operational costs, such as manufacturing, construction, and professional services, use advance payments to cover expenses before delivering goods or completing work. Without this, they might struggle to fund materials, labor, or production.

For businesses handling long-term projects or custom orders, unearned revenue ensures they can commit to a service without financial uncertainty. It also protects against cancellations and improves the operational efficiency of the business.

Unearned revenue VS earned revenue

Unearned revenue and earned revenue represent two different stages in the revenue recognition process. Unearned revenue is money received before delivering a product or service, while earned revenue reflects income from completed obligations.

Common examples of unearned revenue

Many businesses collect payments before delivering a product or service. Whether it’s a retainer for a lawyer, a deposit on a new car, or a prepaid gym membership, these advance payments give businesses financial security while creating an obligation to fulfill. Companies across industries, from retail and software to professional services, handle unearned revenue daily.

Subscription-based services

A subscription-based business charges customers on a recurring basis for continued access to a product or service. This model is common in streaming platforms (Netflix, Spotify), SaaS companies (Microsoft 365, Salesforce), gyms, and online memberships.

When a customer pays for a monthly or annual subscription, the business receives the payment upfront but hasn’t yet provided the full service. For example, if a customer purchases a one-year Netflix plan for $120, Netflix can’t recognize the entire $120 as revenue immediately. Instead, it must classify it as unearned revenue and recognize $10 per month as earned revenue as the service is provided.

Subscription-based companies rely on unearned income to maintain steady cash flow and invest in product improvements. Since over 83% of adults in the U.S. use at least one subscription service, businesses in this space must carefully track and manage deferred revenue to ensure accurate financial reporting.

Advance payments for products

Customers often pay for products in advance when businesses need to secure inventory, manage production, or prevent financial losses from order cancellations. This is common in pre-orders, custom-built products, and high-demand items.

For example, a car manufacturer may accept a $5,000 deposit for a custom vehicle that will take six months to produce. The company receives the cash immediately, but the car hasn’t been delivered, so the payment is recorded as unearned revenue. Once the car is built and handed over, the company can recognize the $5,000 as earned revenue.

Retailers also use prepayments for high-demand items, such as new smartphones, gaming consoles, and luxury goods. This model helps companies predict demand, manage supply chains, and secure funds before production is complete.

Retainers and prepaid services

Many professional service providers, such as law firms, marketing agencies, consultants, and IT service providers, require clients to pay a retainer before work begins. A retainer is an upfront fee that ensures the client has access to the service provider for a certain period.

For example, a law firm may charge a $10,000 retainer for legal representation. The firm holds this amount as unearned revenue and deducts from it as they complete billable work. If the entire amount isn’t used, the firm may refund the client or apply the remaining balance to future services.

For companies managing multiple client retainers, tracking prepayments, and revenue recognition can become complex. Ramp simplifies this by offering bulk transaction categorization and AI-suggested accounting rules, ensuring each retainer is recorded and recognized accurately.

Retainers provide financial stability for businesses that offer ongoing or long-term services. Most professional service firms use a retainer model to manage workload, reduce financial uncertainty, and ensure clients stay committed.

Gift cards and customer deposits

Gift cards are one of the most significant sources of unearned revenue, especially for retail, hospitality, and e-commerce businesses. Customers purchase gift cards in advance, but the business hasn’t yet delivered any goods or services.

For example, when a customer buys a $50 Starbucks gift card, Starbucks receives the payment immediately but cannot recognize it as revenue until the card is redeemed for coffee or merchandise. In some cases, gift card balances go unused, creating "breakage revenue," which businesses must account for based on historical redemption rates.

Similarly, businesses require customer deposits for reservations, event bookings, or large purchases. Hotels, for example, charge deposits to secure room reservations. If a customer cancels, the hotel may keep part or all of the deposit, depending on the cancellation policy.

How do you record unearned revenue journal entries in accounting?

Unearned revenue is recorded at the time of payment and then adjusted over time. For long-term contracts, businesses recognize portions of revenue periodically, ensuring that financial statements reflect actual earnings. Subscription-based businesses, service providers, and companies handling pre-orders update their unearned revenue accounts monthly, quarterly, or as obligations are met.

Step 1: Record the initial payment as a liability

When a business receives an advance payment, it must classify the amount as unearned revenue under liabilities, not income or asset. The payment represents a company’s obligation to deliver a product or service in the future.

For example, a business receiving $12,000 for a one-year subscription service must record the full amount as unearned revenue. The journal entry would be:

• Debit: Cash $12,000 (increase in cash received)
• Credit: Unearned Revenue $12,000 (increase in liability)

The company cannot count this as income yet because it still owes the customer a service.

Step 2: Recognize revenue over time as obligations are fulfilled

As the business delivers its product or service, it transfers a portion of the unearned revenue into earned revenue. This process ensures that revenue is recorded in the correct bookkeeping period.

If the business provides $1,000 worth of services each month, it must recognize that amount as revenue. The journal entry would be:

• Debit: Unearned Revenue $1,000 (reduces liability)
• Credit: Revenue $1,000 (recognizes earned revenue)

This adjustment continues each month until the entire $12,000 has been recognized as earned revenue.

Step 3: Adjust financial statements at the end of each period

At the end of each accounting period, businesses update their financial statements to reflect revenue that has been earned and the amount still classified as a liability.

For example, after three months, the company would have recognized $3,000 in revenue and still hold $9,000 in unearned revenue. These adjustments ensure financial statements accurately represent the company’s revenue and obligations.

Failing to record unearned revenue correctly can lead to misstated earnings, compliance issues, and regulatory fines. Public companies must follow GAAP (Generally Accepted Accounting Principles) or IFRS (International Financial Reporting Standards) to ensure accurate revenue recognition.

Businesses handling large volumes of unearned revenue need efficient tracking and recognition methods. Ramp automates transaction categorization and mapping, ensuring that unearned revenue is recorded accurately and transferred to earned revenue at the right time. With integrations to ERPs like QuickBooks and NetSuite, companies can eliminate manual adjustments and reduce the risk of financial misstatements.

Tax and compliance considerations for unearned revenue

In most cases, businesses don’t pay taxes on unearned revenue until they recognize it as income. The IRS follows accrual accounting rules, meaning businesses only pay taxes when they fulfill their obligations.

However, some exceptions exist. Under IRS Section 451, certain prepayments may be taxable in the year they are received. Businesses that collect advance payments for goods, long-term service contracts, or subscriptions must track revenue carefully to avoid tax errors.

Finance teams, accountants, and tax professionals ensure businesses comply with tax laws, accounting standards, and reporting requirements. Public companies must also follow GAAP (Generally Accepted Accounting Principles) in the U.S. or IFRS (International Financial Reporting Standards) internationally. These rules require businesses to defer unearned revenue and recognize it over time based on contract terms.

Under ASC 606, businesses must recognize revenue only when they complete a service or deliver a product. If they record revenue too early, they risk SEC investigations, financial restatements, and investor concerns.

Businesses need clear documentation of customer contracts, payment terms, and revenue schedules to stay compliant. Many companies use accounting software to track unearned revenue and ensure accurate tax reporting.

Why proper unearned revenue management matters

Unearned revenue plays a critical role in business cash flow, financial reporting, and tax compliance. Companies receive payments before delivering goods or services, but until they fulfill their obligations, this revenue remains a liability on the balance sheet.

Proper management of unearned revenue ensures accurate financial statements, regulatory compliance, and tax efficiency. Businesses that record and recognize revenue correctly avoid misstatements, SEC scrutiny, and costly tax penalties.

Poor unearned revenue management can lead to financial misstatements, tax penalties, and compliance risks. With platforms like Ramp, businesses can automate revenue tracking, eliminate manual data entry, and ensure revenue is recognized accurately. This helps finance teams maintain compliance and focus on higher-level financial strategy rather than fixing accounting errors.