A contract liability arises when a customer pays consideration, or the entity has an unconditional right to receive payment, before a performance obligation is satisfied. This typically occurs in scenarios where customers prepay for goods or services, such as software subscriptions, retainers, or advance payments for future services. For example, if a business receives $10,000 from a customer as a prepayment for a one-year software subscription, this amount would be recorded as a contract liability on the balance sheet until the subscription period progresses, at which point revenue would be recognized.

In accounting, contract liabilities ensure that revenue is matched with the timing of delivering goods or services, aligning with the principles of revenue recognition as outlined in accounting standards. They are often recorded under current liabilities if expected to be recognized within the operating cycle, or non-current liabilities otherwise. Businesses regularly analyze contract liability balances to ensure compliance and proper financial reporting. For instance, a contract liability account might include advance ticket sales for an event that will happen in the future, or deferred revenue related to subscription services.