Prepaid income definition
/What is Prepaid Income?
Prepaid income, also known as unearned revenue, refers to funds that a business receives in advance for goods or services that are yet to be delivered or performed. It is recorded as a liability on the company’s balance sheet because it represents an obligation to provide products or services in the future. For example, a software company that sells annual subscriptions collects payment upfront for the entire year but recognizes the revenue gradually as the service is delivered each month. Until the service is provided, the collected amount is considered prepaid income. This approach ensures that revenue is matched with the period in which the service or product is actually delivered, adhering to the accrual accounting principle. As the business fulfills its obligation, the prepaid income is gradually recognized as earned revenue on the income statement.
Industries Where Prepaid Income is Common
Here are five industries in which prepaid income is common:
Subscription-based services. Companies offering magazines, streaming platforms, or software-as-a-service (SaaS) often require customers to pay for subscriptions upfront. These payments are recorded as prepaid income and are recognized as revenue gradually over the subscription period as the service is delivered.
Airline industry. Airlines receive payments in advance when customers book flights. The money collected is recorded as unearned revenue until the flight is completed, at which point it is recognized as earned revenue.
Hospitality industry. Hotels and resorts commonly require advance payments for room reservations or event bookings. These payments remain as prepaid income until the customer stays at the hotel or the event takes place.
Insurance industry. Insurance companies collect premiums in advance for coverage extending into the future. These premiums are initially recorded as unearned revenue and are recognized as income monthly as the insurance protection is provided.
Construction industry. Construction firms often receive deposits or progress payments before completing phases of a project. These funds are recorded as prepaid income and recognized as revenue only as work is completed and milestones are reached.
Accounting for Prepaid Income
Prepaid income is considered a liability, since the seller has not yet delivered, and so it appears on the balance sheet of the seller as a current liability. Once the goods or services have been delivered, the liability is cancelled and the funds are instead recorded as revenue.
Example of Prepaid Income
Fido Corporation manufactures custom-made dog kennels, which contain elaborate amenities. Since they are designed to the exacting specifications of dog owners, Fido insists on being paid up-front, before construction begins. In a recent case, a wealthy customer pays the company $50,000 for a custom dog kennel. Fido’s accountant records this payment as a $50,000 debit to the cash account and a $50,000 credit to the prepaid income liability account. Once the company delivers the kennel to the customer, the accountant debits the prepaid income liability account and credits the revenue account. These two entries mean that the payment started off as a liability and was then converted into revenue.
Terms Similar to Prepaid Income
Prepaid income is also known as unearned revenue.