Definition of Unearned Revenue
Unearned Revenue is referred to as deferred revenue. It can be defined as a payment that the company receives against goods and services that are not yet delivered. They are meant to be delivered sometime in the future.
In accordance with the accrual principle of accounting, companies are required to record revenues that have been earned, and expenses that have been incurred. In other words, only revenues and expenses relevant to the current year are supposed to be included in the financial statements for the given year. Hence, it can be seen that as per the standards laid out in accrual accounting, revenue is only supposed to be recognized when the company has received the payment, and the products and the services have not yet been delivered to the customer.
Examples of Unearned Revenue
Unearned Revenue is basically a prepayment that has been received from the customer, the order for which has still not been processed. Factually, it can be seen that unearned revenue is a dorm of customer advance, for which order fulfillment has still not been executed.
During the normal course of business, there are several different examples of unearned revenue that are pertinent from the standpoint of the company. Some examples of unearned revenue are as follows:
- Advance Rent Payments Received – If the company has invested in real estate and has received advance rent payments, these advance payments will be categorized as advance rent.
- Annual subscriptions for software licenses – normally software subscriptions are made on a yearly basis in advance. Till the time when the software is not utilized, it is recorded in the financial statements as unearned revenue.
Accounting for Unearned Revenue
Unearned Revenue is considered as a liability from the perspective of the company. This is primarily because of the fact that the company has received an advance, against which work or service has not yet been provided. Therefore, there is a need to categorize unearned revenue accordingly, since the company does not own this amount. In fact, the company merely holds on to this amount in advance, and till the time the order is delivered, it will be regarded as such.
Since this is an amount that is received in advance, the company needs to fulfill this order so that they can properly categorize it as revenue in the financial statements. Prior to that, unearned revenue is considered a Current Liability from the company’s perspective. Hence, it is declared on the Balance Sheet of the company as such.
The reason why it is categorized as a Current Liability primarily lies in the fact that unearned revenue needs to be ‘earned’ before it can properly be recognized as a revenue or an asset from the company’s perspective. Furthermore, normally, unearned revenues are processed within a period of 1 year, since it is unlikely for customers to pay advances for orders that stretch over a period of more than 1 year. However, if a customer prepays for orders that are supposed to be fulfilled for a period of more than 12 months, it is then classified as a long-term liability.
Journal Entries for Unearned Revenues
Unearned Revenue is a form of current liability for the company. Therefore, when the company receives unearned revenue from the customers, it is supposed to be recorded in the financial statements as a credit entry in the form of current liability. The corresponding debit entry is an addition t the bank account company. This is illustrated as follows:
|Unearned Revenue – Current Liability||xxx|
The journal entries mentioned earlier depict the debit to the bank account to reflect the receipt of funds. The corresponding credit entry is an increase in Current Liability.
Once the unearned revenue is earned, i.e. the order has been processed and delivered, the following journal entries are made:
|Unearned Revenue – Current Liability||xxx|
The journal entries above show the credit to the revenue account to record sales once the order has been properly fulfilled. Since the amount previously received is no longer unearned, it can be removed altogether from the liability account.
What is the normal balance for unearned revenue?
In accordance with the accounting principles, revenue is always credited in the financial statements. However, in the case of unearned revenue, different accounts are involved.
As mentioned earlier, when customers pay in advance, it impacts the bank account and the unearned revenue account. Unearned revenue accounts are separately maintained to record all amounts received from customers, which the company has not yet processed.
Since this is a liability from the standpoint of the company, it always has a credit balance. This is because the company has received the amount, but has not yet earned the amount.
Example of Unearned Revenue
The concept of unearned revenue is illustrated in the following example:
Feliz Inc. is an internet service provider based in California. They receive payments in advance from their customers, for the internet services that they use in a given month. On 1st December 2019, they launched an offer under which customers were supposed to pay upfront for 3 months, as a result of which the service charges were to be waived by the company.
During this period, they collected total customer advances equivalent to $12,000. This amount was considered an advance for the service period 1st January 2020 till 31st March 2020.
The scenario presented above shows that customer advances that Feliz Inc. received were supposed to be categorized as unearned revenue for the year ended 31st December 2019. In order to record this, the following journal entries were made:
|Unearned Revenue – Current Liability||$12,000|
The journal entry above shows that the bank is debited in order to reflect the incoming funds in the form of customer advances. However, since the internet service has not been provided against these advances, a corresponding credit entry is made to showcase the current liability of the company. Furthermore, it is also important to note that the current liability is recorded in the form of unearned revenue.
Once the service has been provided, i.e. on month ends, the unearned revenue account would be subsequently reduced. For example, the journal entry to adjust for the unearned revenue on 31st January 2020 would be as follows:
|Unearned Revenue – Current Liability||$4000|
Hence, as per the accrual concept, revenue is going to be recorded as they are earned by the company. When the three-month period ends, there would be no unearned revenue pertaining to this transaction. This implies that all the revenue that was previously received in the form of customer advances recorded as unearned revenue would be zero. All the amount would have been recognized and subsequently recorded as revenue.