The income statement and statement of cash flows can create confusion because of the possibility of cash inflows without income and the other way around. One possible source of this confusion is unearned income, which has an immediate effect on the statement of cash flows and a delayed effect on the income statement.
Statement of Cash Flows
The statement of cash flows shows all of the activities that either disbursed or generated cash for the company during a certain period. The cash flow statement divides into three sections: operating, investing and financing. The operating section describes all of the company's activities in its core day-to-day operations. The investing section describes all of the company's activities in buying equipment, companies, and stakes in other companies. The financing section describes all of the company's transactions with its capital providers including share issuance, debt repayments and dividends.
Unearned revenue is usually cash a company receives in advance of performing a service or providing a good. As the company has not yet performed the service, this cash revenue displays as unearned. Note that a payment does not actually have to be present, unearned revenue could also be an agreement to pay the company at a later date in the form of an accounts receivable.
Effect on Cash Flow Statement
If the payment is on account, there is no effect on the cash flow statement. If the payment is in cash, a cash inflow appears in the operating section of the cash flow statement. Because the company receives the cash flow in advance of producing a good or a service, this means that when the company actually recognizes the revenue this will just be on the income statement with no cash inflow on the cash flow statement. Therefore, it is possible to have cash inflows but no income and to have income but no cash inflows.
Companies with large unearned revenues are companies that receive cash well in advance of the service performed or good produced. One example of this is the insurance industry. Individuals pay the insurance company ahead of the insurance service the company provides so that the company has a large cash inflow that it can recognize well before it recognizes the revenue. The companies that rent out real estate are another industry with large unearned revenues. As individuals usually pay rent on the first day of the month, the rental company receives a large cash inflow before it performs the services for which the individuals pay rent.
Alex Shadunsky has a bachelor's degree in finance and is pursuing a Master of Business Administration from Indiana University. He has worked at Briefing.com as a junior equity analyst specializing in health-care stocks.