Despite its name, unearned revenue is not actually treated as revenue. So, what is unearned revenue? Where is unearned revenue reported in the financial statements?
What Is Unearned Revenue?
At first, unearned revenue is money received by a company for the products or services that have not yet been provided. Some people consider it as a prepaid amount for services or goods that a company promises to deliver to its customers in the future. This prepayment is recognized as an obligation of a company (also referred to as “liability”) until the products are supplied, or the services are rendered. Unearned revenue may also be called “deferred revenue”, “advance payment,” or customers’ deposits.
Where Does Unearned Revenue Go?
It should be noted that unearned revenue is reported in the financial statements as follows:
When arising, unearned revenue is classified as a “liability” as the revenue has not yet been realized, and the product or services are not provided. Moreover, it reflects the company’s future obligation; therefore, it is recorded as a liability in the balance sheet.
The company then gradually fulfills its obligation, and the unearned revenue is actually gained due to the provision or delivery of goods or services. The entries will be adjusted accordingly. The liability will be removed, and then the generated amount is booked as revenue in the income statement.
In brief, unearned revenue is reported in the financial statements as: (1) a liability in the balance sheet and (2) a revenue in the income statement.
Kinds Of Companies Can Gain Unearned Revenue
In general, a magazine or newspaper publisher collects money in advance for a year’s subscription. That is to say, the customer can enjoy a year’s subscription by paying a premium in advance with favorable discounts.
In general, Airlines ticket suppliers or companies always sell tickets to their clients in advance. When you buy a ticket, you are booking a seat on a plane. Then, the airlines will recognize advanced collections as earned revenue once the flight with a seat you reserve is delivered at a specific date.
In reality, many companies in the construction industry or furniture industry always ask for a portion of a total sale as an advance payment. This payment is first recorded as unearned revenue and turned into earned amounts until they deliver the finished goods.
Accounting For Unearned Revenue
Then, to record unearned revenue correctly, you should keep in mind a simple two-step process:
1st Step: Recording The Initial Payment:
At this stage, the cash is paid before the service is provided, or the good is delivered. Cash accounts will be debited, and the unearned revenue will be entered in the liability category with a credit side.
2nd Step: Making Adjusting Entries When The Revenue Is Actually Earned:
Unearned revenue account will be zeroed out on the debit side. Conversely, the revenue account will be credited.
An Example Of Unearned Revenue
Then, let’s take a look at a typical example below and learn how to record unearned revenue:
On 1st January, a contractor received $12,000 for the construction items that are to be completed over six months. This total amount will be recorded as unearned revenue since the work portion is yet to be finished.
As a result, the journal entry records the early payment as follows:
|1st January||Unearned revenue||$12,000|
Note that the advance amount has not yet been earned; thus, it goes on a liability account representing a contractor’s responsibility. Supposed on 31st January, 25% of the work is completed. The adjusting entry should include: (1) recognition of $3,000 revenue rendered and (2) a decrease in unearned revenue since a portion of work has finished.
|31st January||Unearned revenue||$3,000|
In the next months, we simply calculate the earned part from the unearned revenue and adjust entries until the balance of unearned revenue is zero.
Benefits Of Unearned Revenue
Although unearned revenue is identified as a “liability” in a balance sheet, it brings many benefits to businesses. Let’s see:
Create A Positive Cash Flow
Certainly, if the company gains high unearned revenue, it will enjoy a cash flow surplus. As a result, this helps the company to determine its financial health more precisely in the near future.
Improve Working Capital
In fact, working capital is a business’s bone to cater for daily operations and cover costs incurred. Many small companies fall into operation discontinuities when being short of working capital. Hence, they always raise capital by taking out loans from banks and suffer a financial burden from the interest.
On the other hand, by requiring their clients to pay in advance, managers can have the considerable upfront capital to provide the promised goods and services at zero interest rate. Additionally, high unearned revenues can show potential investors how much revenue they can gain in the upcoming time. Also, this demonstrates a high level of customers’ trust, which increases a company’s value.
To Sum Up
All in all, although unearned revenue is considered a liability in an accounting field, the businesses still get many advantages from it. Therefore, an accountant must treat this account precisely to realize the company’s true financial status.