Unearned Revenue, also known as deferred revenue, is money received by a corporation from a consumer for goods or services given later. The term comes from accrual accounting, which recognises revenue only when a corporation receives cash and the goods or services have not yet been provided to the consumer.
Prepaid rent payments, yearly software licencing subscriptions, and prepayment insurance are all examples of unearned revenue. Insurance firms and software as service businesses frequently recognise deferred income.
Prepaid revenue is the accounting term for unearned revenue. This kind of revenue is money paid upfront to a company before it supplies customers' products or services. Unearned revenue is a debt, which is money owed to a corporation. Adjustment entries are made when the products and services are delivered. Cash flow is aided by unearned revenue.
Did you know?
Henry George used the phrase "unearned revenue" to promote the economic notion of economic rent and "rent" in particular.
Unearned Revenue: An Overview
- Companies that sell premium account goods or other services that need prepayments are the most likely to have unearned income. These classic examples are paid rent, prepaid insurance, professional retainers, airfare, full payment for newspaper subscriptions, and yearly prepayment for program use.
- Receiving payment before a service is completed can be advantageous. Early cash flow is used for various purposes, including paying loan interest and acquiring more inventory.
- Bear in mind that unearned revenue can only be recorded by companies that employ the accrual method of accounting.
- Businesses must follow many accounting rules in accrual accounting, which determine when bookkeeping is completed.
- One of these concepts is revenue recognition, which argues that money should be recognised when earned, not paid in cash.
- Unearned revenue, on the other side, does not exist as a record on a cash basis (a different accounting system to accrual) since revenue is only documented after cash flows in.
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Unearned Revenue Accounting
Suppose a publisher takes ₹1,200 each year for a subscription, in that case, the money is reported as an increase in cash and unearned revenue. The trade has no immediate effect on the financial statements because both accounts are balance sheet accounts. If it's a monthly magazine, the obligation (or unearned revenue) is decreased by ₹100 (₹1,200 divided by 12 months) as each month is delivered, while income increases.
Unearned revenue is typically reported on a company's balance sheet as current debt. If you pay in advance for services or items delivered twelve months or over after the settlement date, this changes. Unearned revenue will reflect on the balance sheet as long-term debt in such circumstances.
According to accounting statement requirements, unearned revenue is a corporation's responsibility for receiving the money (therefore generating a liability) but has not yet performed work or delivered products. Despite obtaining payment from a consumer, the corporation still obligations the delivery of products or services. The business will owe the money paid by the consumer if the firm fails to fulfil the offered service or product or if a client cancels the transaction.
As a result, revenue must be recorded as a liability at first. It's worth noting that after the products or services are delivered, the revenue that was frequently reported as a liability is now registered as revenue (i.e., the unearned revenue is then earned).
Unearned revenues are often categorised as short-term debts because the debt is generally satisfied in less than one year. However, where the supply of products or services is expected to take more than one year, the unearned revenue may be recorded as long-term debt.
Suppose a corporation does not deal with unearned revenue and instead recognises it all at once. In that case, sales and profits will be overestimated and later underestimated for the periods in which the revenues and earnings should have been recognised. Revenues are recognised immediately, but associated expenses are not recognised until subsequent periods, which breaches the matching principle.
Some Examples of Unearned Revenue
Example No. 1
XYZ International engages Europa Plowing to plough its parking lot and paid ₹10,000 in front so that Europa will prioritise ploughing during the wintertime. Europa has not yet collected the income at the time of payment. Thus, it records the entire ₹10,000 in an unearned revenue record, using the following unearned revenue entry:
|
Debit |
Credit |
|
|
Cash |
10,000 |
|
|
Unearned revenue (liability) |
|
10,000 |
Europa anticipates ploughing for XYZ for five months; therefore, it chooses to recognise ₹2,000 in unearned income per month for each of those five months. Europa reports the accompanying unearned revenue entry in the first of the five months:
|
|
Debit |
Credit |
|
Unearned revenue |
2,000 |
|
|
Ploughing (revenue) |
|
2,000 |
Unearned income is recognised when there is proof of actual usage, which is a variant of the revenue detection method mentioned in the previous example. Europa Plowing, for example, would have chosen to recognise the unearned revenue based on the estimate that it will plough for XYZ 20 times over the winter. As a result, if it ploughs five times in the first month of the winter, it could justifiably recognise 25% of the unearned revenue. This method is more accurate than straight line detection, but it is dependent on the correctness of the baseline amount of units to be absorbed (which may be inaccurate).
Example No. 2
A client prepays for a dog walking package. The plan includes three months of walking. The cost is ₹1200 per month at ₹400 per month. The client makes a one-time payment of ₹1200. The firm owner deducts ₹1200 from cash and credits ₹1200 from unearned earnings.
The business owner then chooses to keep track of the accrued revenue on a monthly. Earned revenue is recorded in an accrual, a type of adjusting journal entry.
The owner deducts ₹400 in unearned income and credits ₹400 in revenue at the end of the month. He continues to do so until the three months are up, and he has reported that the full ₹1200 is generated and collected revenue.
Example No. 3
A customer paid ₹2000 for a bundle of 20 individual training sessions or ₹100 for each session. She paid for them ahead of time. The personal trainer debits ₹2000 from cash and credits ₹2000 from unearned revenue.
The customer does not attend training classes on a routine basis. She takes five personal training sessions after 2 months. This implies she's completed 25% of her 20 scheduled sessions. As a result, the trainer might record 25% of unearned earnings, or ₹500 worth of sessions, in their records. She deducts ₹500 from unearned revenue and credits ₹500 to revenue.
Also Read: How Does Profit Work in a Business?
Is it true that unearned revenue is a liability?
Yes, in a word. Unearned revenue should be reported as liability according to financial statement requirements. The company's revenue is exaggerated for that income statement if the value was reported as a property rather than a liability. Assets must equal the total equity plus liabilities, as per the accounting equation. The books would become unbalanced as a result of this.
Generally accepted accounting principles are also broken if revenue is not recorded in the same accounting period as expenses are paid. As a result, any corporation that has already taken payment without providing the product is liable for excessive revenue. The firm will still owe the money to the consumer if it fails to fulfil. Thus it cannot be recognised as revenue just yet. The payment shifts from liability to income after service.
Because commitments are met within a year, unearned revenues are generally called short-term liabilities. When considering a solution that will take more time than a year to deliver, individuals inquiring about "is unearned revenue a burden in the long run" may be proven true. Unearned revenue should generally be documented as a long-term responsibility in these situations.
Conclusion
The cash received from a consumer for products or services which have yet to be provided or created is known as unearned revenue. Unearned revenue, often known as deferred revenue, is an obligation on a balance sheet that must be earned by satisfactorily delivering products and services to a consumer. Unearned revenue is reported as a debit to the money account and a credit to the unearned income statement on a balance sheet. Unearned revenue is a prevalent accounting problem, especially in service-based businesses. You can keep the accounts balanced by considering them a liability for financial reasons. Unearned revenue could often offer a unique perspective into a firm's possible future revenue, which is helpful for productive investments.
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