Definition of a Contract Liability
Contract Liabilities are also referred to as deferred or unearned revenue. A contract liability is basically an obligation on the part of the entity to transfer goods and services to a given customer for which the entity has already received consideration from the customer.
In other words, contract liability is the amount that has been received by the customer, the performance obligation for which is yet to be carried.
Contract Liability occurs in two main cases:
- When the customer prepays for a particular sale consideration
- When the customer’s consideration is due for goods and services that are yet to be provided for by the company.
Therefore, contract liability mostly results whenever a customer pays in advance, or some parts of the service contract need to be fulfilled.
Contract Liabilities mostly occur in the case of contracts that span across a relatively larger time span. For example, heavy capital machinery or construction-related projects. It is important to understand the fact that contract liabilities are mostly relevant for industries that involve one-off orders.
Companies that mostly have regular batch production do not normally need to record contract liabilities, because orders can be serviced as soon as the organization wants – since they have inventory on hand.
Revenue Recognition Principle and Recognition Criteria for Contract Liability
In accordance with the Revenue Recognition Principle, organizations are only supposed to record revenues when they have been ‘earned’. This implies that revenues should be recorded only when they work against the service contract has been fulfilled.
In the case where the customer pays in advance for a certain good or service, and the organization is yet to provide the services (or goods) against this, it cannot be classified as revenue.
This is because this revenue is ‘unearned’, and needs some performance obligations to be completed before it can be classified as revenue in the financial statements.
Therefore, contract liability is created in the case where the customer pays in advance, and the organization still needs to complete the performance obligations for the revenue to be recognized as revenue. Before that, it will be treated as a contract liability in the financial statements.
By nature, contract liability is a Current Liability, if the organization is likely to complete the performance obligation in a period of less than 12 months.
However, if the project spans a longer time duration, in that case, contract liability might also be treated as a Non-Current (or Long-Term) liability.
Difference between Earned Revenue and Unearned Revenue
Unearned Revenue is defined as an amount received from a customer for goods and services that need to be prepared at a later date. On the other hand, earned revenue is the amount that has been received (or is supposed to be received) for goods and services that have already been provided by the organization.
Unearned Revenue has entries involving the bank, and a Current Liability account (since it is a customer advance). On the other hand, earned revenue involves the bank (or Accounts Receivables), and the Revenue Account.
- Unrecorded Revenue and Unearned Revenue: Unrecorded revenue refers to revenue that the company has not yet recorded. This might be because of the relative uncertainty involving a certain contract, because of which it was chosen to be left unrecorded by the accountants.
Accounting Treatment and Journal Entries required for Contract Liabilities
During the normal course of the business, when a sale is made on credit, the following transaction is made:
|Debtor – Accounts Receivable||xxx|
The journal entry above highlights the fact that the sale has been finalized, the inventory (or the service) has already been provided for. However, in the case where the customer has paid the organization in advance, the following journal entries are required:
The transaction above shows the incoming amount, as a result of the customer prepayment. Since this amount is not yet fulfilled by the company (i.e. performance obligation has still not been carried out against this order), it is recorded as a contract liability.
After the performance obligation has been fulfilled, the company can realize this amount as revenue. This is in line with the Revenue Recognition principle. After the services have been provided (or goods have been delivered), the following journal entries are required:
The journal entry above reflects the transfer from contract liability to the Revenue Account, once the transaction has been complete, and is settled for.
Example of Contract Liability
The concept of Contract Liability is illustrated in the following example:
Brings Co. is a manufacturing concern that produces heavy machinery for construction industries. They take partial payments from customers in advance, after which they begin the production process of the relevant machines.
Recently, they received an order from Goop Co. for industrial machines worth $100,000. Goop Co. paid the entire amount in advance. The machines were expected to be delivered in a period of 10 months.
In the scenario mentioned above, it can be seen that Brings Co. has taken an advance amount equivalent to $100,000 from Goop Co. Brings Co. plans on beginning work on the contract once the payment has been finalized.
Currently, they do not have any performance obligation met, against which they can realize this amount as a completed sale.
Therefore, the advance that has been received from Goop Co. is supposed to be realized as a Contract Liability in the books of Brings Co. This is because this is an unearned revenue, and it can only be realized after Brings Co. delivers the goods to Goop Co.
In order to record the receipt of payment from Goop Co., Brings Co. needs to make the following journal entries:
After a period of 10 months, when the goods are actually delivered to Brings Co, the following journal entries need to be made:
The journal entries above show the removal of contract liability. This is after the revenue has been ‘earned’ as a result of the delivery of the machines.
Before the revenue is recognized (in accordance with the revenue recognition principle), the amount of Contract Liability (i.e. $100,000) is going to be recognized as a Current Liability in the financial statements.
Once the performance obligation has been carried out (i.e. machines have been delivered to Goop Co.), the amount is going to reflect in the Income Statement as a Revenue.
Difference between Contract Liabilities and Trade Payables
Given the similar accounting nature (and treatment) of both, Contract Liabilities, and Trade Payables as Current Liabilities, there is a very major difference that needs to be accounted for.
Trade Payables exist as a result of the organization ‘purchasing’ goods and services on credit. This implies that companies have received the goods and services, for which they have not paid the amount as yet.
On the contrary, Contract Liabilities exist as a result of customers paying in advance to customers.
In order to settle Trade Payables, the organization needs to pay cash to the suppliers. On the other hand, in order to settle Contract Liabilities, organizations need to complete certain performance obligations or deliver goods in order to settle Contract Liabilities.