Definition of Unearned Revenue
Unearned revenue refers to the amount of money received by an entity against which the goods or services have yet to be provided. It represents the advance amount that an entity receives from its customers against the goods or services to be provided in the future. It is treated as a liability in the books of accounts.
Explanation
The accounting principles suggest that an income shall be recognized only when the same is earned. Revenue is said to be earned only when the performance obligation for the provision of goods or rendering of services is completed. If any consideration is received from the customer before the performance obligation is met, the amount received is known as unearned revenue and represents a liability for the entity. Once the goods have been delivered or services have been rendered as per the contract, then unearned revenue is reversed, and revenue is booked.
Example of Unearned Revenue
Suppose a buyer contracted with the seller for the delivery of goods in 5 lots, each lot containing 100 units on 01.01.2020. The price per lot is $2,000. The seller had delivered 2 lots as of 01.02.2020. The buyer paid $10,000 to the seller on 01.02.2020. What shall be the amount of unearned revenue in this case as of 01.02.2020?
Solution:
In this case, 3 lots are yet to be delivered as of 01.02.2020. However, the payment for these 3 lots has already been made by the buyer to the seller along with the payment of the initial 2 lots. Since payment has been made in advance for the 3 lots, unearned income is required to be booked for these 3 lots.
Unearned Income = Number of Lots Undelivered × Price per Lot
- Unearned Income = 3 × $2,000
- Unearned Income = $6,000
Accounting for Unearned Revenue
It is classified as a current liability in the books of accounts. This is because the advance amount received represents a liability against which performance obligation has yet to be completed. Once the performance obligation is met, i.e. goods or services have been provided, then the actual revenue is booked, and the amount of unearned revenue is reduced. The accounting entries shall be as follows:
When an advance is received from the customer:
| Dr. Bank | $6,000 |
| Cr. Unearned Income | $,6000 |
When performance obligation is met, and revenue is earned:
| Dr. Unearned Income | $6,000 |
| Cr. Revenue | $6,000 |
Importance of Unearned Revenue
- it is an important term in accountancy. If income is booked instead of booking unearned revenue, then revenues and profits will be overstated and would mislead the users of the financial statements. Further, for the next periods, the revenues and profits would be understated.
- The concept of unearned revenue also helps to maintain the matching principle of accountancy, which states that revenues should be matched with the related expenses. If revenues are booked when consideration is received, and expenses are booked later when incurred, it would defeat the matching principle.
- For these reasons, unearned revenue is booked as a liability and reversed only when the actual delivery of goods or provision of services takes place.
Unearned Revenue vs Deferred Revenue
It is also known as deferred revenue, and both terms convey the same meaning. They reflect an amount received in advance by the company for the goods or services that have to be provided in the future. Since revenue is not earned, its recognition as an income has to be deferred until it is earned. The amount of advance forms part of the current liabilities of the entity and is reversed when revenue is earned.
Benefits
- It is an advance received from the seller and increases the cash flows of the seller, thereby assisting in carrying out more business activities.
- The amount received as an advance increases the liquidity of the entity.
- Recording unearned revenue gives a true and fair view of the revenues of the seller, thereby eliminating any chances of confusion.
- It helps to maintain the matching principle of accountancy.
Disadvantages
- It represents the current liability of the company.
- The goods or services have yet to be provided, which creates a burden for the seller to fasten up the process since the amount has already been received.
Conclusion
It is a common accounting term that can be found in the financial statements of any entity. It is relevant for both trading as well as service industries. It is in the nature of advance and reversed later when revenue is earned.
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