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What is 'Unearned Revenue'

Unearned revenue is money received by an individual or company for a service or product that has yet to be fulfilled. Unearned revenue can be thought of as a "prepayment" for goods or services that a person or company is expected to produce for the purchaser. As a result of this prepayment, the seller has a liability equal to the revenue earned until delivery of the good or service.

BREAKING DOWN 'Unearned Revenue'

The early cash flow to the firm is advantageous for any number of activities, such as paying interest on debt to purchasing more inventory. However, by accepting unearned revenue, the firm has then entered a legal obligation to deliver on the terms of the payment. For example, with a prepayment on a lease contract to a real estate company, the revenue is a liability until it is earned.

Criteria to Recognize Revenue

There are several criteria established by the U.S. Securities and Exchange Commission (SEC) that a public company must meet to recognize revenue. If these are not met, revenue recognition is deferred. According to the SEC, there must be collection probability, or the ability to make a reasonable estimate of an amount for the allowance of doubtful accounts; completed delivery, or ownership shifted to the buyer; persuasive evidence of an arrangement; and a determined price.

In Practice

If a publishing company accepts $1,200 for a one-year subscription, the amount is recorded as an increase in cash and an increase in unearned revenue. Both are balance sheet accounts, so the transaction does not immediately affect the income statement. If it is a monthly publication, as each periodical is delivered, the liability or unearned revenue is reduced by $100 while revenue is increased by the same amount.

Example

Morningstar offers a line of products and services for the financial industry, including financial advisors and asset managers. Many of its products are sold through subscriptions. Under this arrangement, many subscribers pay up front, and receive the product over time. This creates a situation where the amount is recorded as unearned revenue, which Morningstar refers to as deferred revenue.

At the end of the first quarter of 2016, Morningstar had $161 million in unearned revenue. This is up from $140.7 million from the year-ago period. The company classifies the revenue as a short-term liability, meaning it expects the amount to be paid over one year. Although unearned revenue can provide clues into future revenue, investors should note the balance change could be due to a change in the business. Morningstar increased quarterly and monthly invoices, and is less reliant on up-front payments from annual invoices, meaning the balance has been growing more slowly than in the past.

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