Unearned Revenue is revenue that the company has received in advance of providing the goods or services. Some companies require customer deposits and/or advanced progress payments prior to beginning or completing the sale. Accounting dictates that revenue is only recognized once the sale is complete; therefore, the money collected through deposits and/or advance payments is considered “unearned” and cannot be recorded on the income statement as revenue until the sale is complete. Therefore, the money collected should be recorded on the balance sheet as a liability account.
Unearned revenue can complicate the cash flow structure and requires companies to actively monitor their cash flow. Although the money collected is recoded on the balance sheet versus the income statement the cash is usually deposited in the same bank account. If the amount of cash collected from unearned revenue is not monitored properly, without realizing it companies may begin paying current expenses from future cash flows. A company’s cash flow may be comprised of a significant amount of unearned revenue (deposits and advanced payments) in addition to the profits earned from previous sales.
If the company purchases goods on credit, a portion of the profits in the bank account should be allocated to paying the accounts payables as they become due. In cases where the company has not produced profits in excessive of the expenses the company may begin dipping into the available cash from deposits to pay past due bills. This should be a warning sign to management to increase revenues, profit margins, reduce expenses or a little bit of all three. However, this warning can go undetected if the company does not properly monitor the amount of cash in the bank from completed sales versus deposits. It will only become evident when the next anticipated project (and deposit) is lost or delayed. Without the new cash the company will suddenly experience a cash flow problem, unaware that the problem had been mounting for some time. Proper financial management would have allowed the managers to proactively identify this problem and make the appropriate changes in the business model before it became a crisis situation.
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