Unearned revenue is what type of account? There are situations whereby companies receive payment from customers for goods or services that are yet to be provided. This income received is not earned yet as the company has a financial obligation to the customer. For the income or revenue to become earned, the company must provide the good or service that the customer paid in advance for. In this article, we shall look at what unearned revenue implies, the account it falls under, its journal entries, and its importance to a business.
What is unearned revenue?
Unearned revenue refers to the money that a business receives from a customer for work that is yet to be performed. It is essentially for goods or services whose delivery will take place at a later date. This commonly has to do with situations whereby the seller has power over the buyer or in situations where the seller is providing customized goods to the buyer. Unearned revenue is also known as deferred revenue or advanced payments.
Due to this prepayment, the seller has a liability that is equal to the revenue earned until he delivers the good or service. It is a liability noted under current liabilities as this obligation is expected to be settled within a year.
From a cash flow perspective for the seller, this possesses an advantage who has the cash to perform the required services or to provide the required goods. It can also be beneficial as it allows the seller to perform other activities such as making an interest payment on debt and making purchases of more inventory. Once the seller delivers the product or service, unearned revenue becomes revenue on the income statement.
Unearned revenue is most common among companies that sell subscription-based products or other services that require prepayments. Examples of such include rent payments in advance, prepaid insurance, airline tickets, legal retainers, prepayment for newspaper subscriptions, and annual prepayment for the use of the software.
It is important to note that the recording of unearned revenue is only valid for businesses that make use of the accrual basis of accounting. In accrual accounting, businesses are required to comply with several accounting principles that dictate when bookkeeping is done. One of these principles has a close relationship with revenue recognition and states that revenue should be recorded when it is earned, rather than when the seller or business receives cash. On the other hand, with a cash basis which is the alternative method to accrual, unearned revenue does not exist as an account because the keeping record of revenue only takes place once cash flows in.
Unearned revenue is what type of account?
On a company’s balance sheet, unearned revenue is recorded as a liability, therefore, it is a liability account. It is treated as a liability because the business still has not yet earned the revenue and it represents the products or services owing to a customer.
As the prepaid service or the business gradually delivers the product over time, it is recorded as revenue on the income statement. As previously stated, unearned revenue is usually recorded as a current liability on a company’s balance sheet. If for example, a publishing company accepts $1,200 for a year subscription, the amount will be recorded as an increase in cash as well as an increase in unearned revenue. Both are balance sheet accounts, so the transaction will not have an immediate effect on the income statement. If it is a monthly publication, the liability or unearned revenue will be reduced by $100, that is, $1,200 divided by 12 months while revenue is increased by the same amount.
Usually, unearned revenue is disclosed as a current liability on a company’s balance sheet. There will be changes in this if advance payments are made for goods or services due to be provided 12 months or more after the payment date. If such cases occur, then unearned revenue will appear as a long-term liability on the balance sheet. In essence, unearned revenues are generally classified as short-term liabilities because the obligation is usually fulfilled within a period of less than a year. In some cases, the delivery of goods and services may take more than a year, in this case, the unearned revenue will be recognized as a long-term liability.
In essence, the accounting reporting principles state that unearned revenue is a liability for a company that has received payment for the provision of goods and services that have not been delivered or completed. The rationale behind this is that despite the fact that the company receives payment from a customer, it still owes delivery of a product or service to a customer. If the company fails to deliver the promised product or service, or the customer cancels the order, the company will owe the money the customer paid. Therefore, one must initially recognize the revenue as a liability, then when the delivery of the goods and services is complete, the revenue that was previously recognized as a liability will be recorded as revenue. This means that the initially unearned revenue is now earned.
Related: Revenue: Debit or Credit?
Recording unearned revenue
To record unearned revenue, there is a need to make two journal entries. One is to recognize the prepayment while the other is to convert it into service revenue as it is earned. In accounting, the record of prepayments takes place as a credit to unearned revenue and a debit to the cash account. With debit, the balance in the unearned revenue account is reduced while with a credit, the balance in the revenue account is increased. Once the order of the service is completed, an adjusting entry is made which debits unearned revenue and credits service revenue otherwise known as sales revenue.
If the company was not to deal with unearned revenue in this manner, and instead recognize it all at once, there would initially be an understatement in revenues and profit. On the other hand, there will be an understatement for the additional periods during which the revenues and profits were supposed to have been recognized. This also violates the matching principle since the company recognizes the revenues at once while it does not recognize related expenses until later periods.
On February 1st, a customer paid $10,000 for installation services which will be done in the next five months. The amount received would be recorded as unearned revenue. This liability will subsequently reduce and the revenue will be recognized on a monthly basis.
Given this information, the following journal entries will be recorded:
|Unearned revenue account
The monthly adjustment will be as follows:
|Unearned revenue installation account
|Installation income account
Importance of unearned revenue
- Sooner access to money
- Increase in working capital
- Clients can break up payments
Although unearned revenue is a liability in the books, the above-mentioned are the benefits it possesses for small business owners.
Sooner access to money
Everyone needs cash to survive. One cannot always count on clients to pay on time and not getting paid can affect one’s cash flow, especially if a late payment means suddenly spending more than what is earned in a month. In this case, the best defense is collecting revenue in advance before starting a new project. By charging a deposit upfront, one will keep cash flow positive thereby staying afloat.
Increase in working capital
It is the dream of every business owner to experience an increase in working capital. In this case, a lot of upfront capital is required since it is crucial for a business to cover its daily operations and payroll costs.
Clients can break up payments
Clients also have to put their cash flow into consideration. With this, breaking up payments into smaller installments can be helpful. For example, clients can be given the option to pay in advance for a whole year and a discount will be offered to them for doing so, or they can be allowed to pay in installments at major milestones.
When to recognize unearned revenue
According to ASC 606, it is required for businesses to recognize businesses when they have delivered products or services that equal the amount in exchange for those products or services. The following steps are included in the process:
- Find and review the contract with the customer.
- Identify the business obligation in the contract.
- Determine what amount is appropriate for the transaction.
- Allocate the amount towards the obligation in the contract.
- Recognize the revenue then the obligation has been satisfied by the business.