Business is a complex system with many components. An entrepreneur manages sales,develops a product, sets up marketing, and manages employees. Parts of the systemare interconnected – there will be no sales without marketing; without staff, there is noone to develop the product. Business relationships can be challenging to track andevaluate. But they are all reflected in finances – the heart of a business that helps moveit forward.
Companies usually keep two reports on money management: accounting and finance.Accounting reports are created to be submitted to the tax and other authorities, andfinancial accounting helps to see the real situation with money in business and makedecisions. Often the owner draws up financial statements independently or together withthe financial manager. What role does unearned revenue play in these financial reportsand business in general?
Unearned Revenue Definition
Many businesses require or sometimes come across instances when their customers pay for the product or service in advance. Unearned revenue is income received but not yet earned, such as rent paid in advance or another advance payment received from customers. Therefore, unearned revenue is also often referred to as “advances from customers.”
The reason behind requiring customers to pay before they receive a product is that a company can secure a sale, reducing the risk that customers will change their mind about a product, especially if it is custom. The customer, in turn, can secure a product or service at a specific price. The business also gets funds for the production of the product or purchase of materials required to provide a service. These funds will be circulating in the company and helping it to make money without having a significant capital.
How to Calculate Unearned Revenue
It is effortless to calculate how much unearned revenue a company has, especially if thecompany adheres to the Generally Accepted Accounting Principles and uses a liabilityreporting method. Looking at the records of advance payments and adjusting entries,one can calculate the amount of revenue that is still considered a liability.
This number will be recorded in the balance sheet under liabilities because thecompany still must perform a service or provide a product. The first step in thecalculation is confirming the amount of money received in advance. A check, a salesinvoice, or a purchase order can all be used for this. The sales invoice or the purchaseorder will not only tell the amount that was paid but also the number of months for whichthe payment is made. Adjusting entries will indicate how much has been earned at themoment of calculation/preparation of a report.
For example, an office paid $1,000 for lawn care services that will be providedthroughout the year. At the end of the first quarter, a company prepares reports, andsince they provided only a portion of the services, there will be adjusting entries for thefirst three months totaling $250. The unearned revenue will respectively amount to$750. In the adjusting entry, the Unearned Revenue account will be debited for $250,which will decrease it, and credit Sales Revenue account for the same amount toincrease earned revenue and record the income.
Unearned Revenue on Balance Sheet
To make management decisions, the business owners and managers need information.It is useful for them to see the business as a whole – to evaluate and understand all thedetails. For this purpose, there is a balance sheet. The balance sheet summarizes allthe assets of the company – what it owns and liabilities – resources of funds for itsoperations. That is, on the one hand, this is equipment, raw materials, and goods instock, and on the other hand, loans, investments from outside and retained earnings.
One of the most frequent questions asked about unearned revenue is “Is unearnedrevenue a current liability on a balance sheet? Unearned income in a company’sbalance sheet is usually treated as a current liability, and it is anticipated that it willsubsequently be credited to the income account during the relevant reporting period.However, let’s review the answer in details.
First, one needs to understand what a current liability is. A current liability is the amountof debt to the creditors or suppliers, which lasts during the normal operating cycle or isrepaid within 12 months from the date the balance sheet of the company is prepared. Inother words, a current liability is due within a year.
Thus, one can consider unearned revenue a current liability if the company will earn itwithin one year or the current operating cycle, whichever is longer. In other words,payments that are received in advance are made for goods or services that customersexpect to collect within a year.
Now, let’s figure out why unearned revenue is considered a liability. As it was alreadymentioned in the definition, unearned revenue is income that is already received but notyet earned. In other words, this means that the company has not however performed aservice or delivered goods and it owes the goods/service a customer paid.
In the following section, we will review two ways to record unearned revenue and whatjournal entries will be made when the payment is received and when a service orproduct is partially or fully delivered.
Reporting and Bookkeeping Methods
As you just learned, unearned revenue is a current liability, an obligation to provideeither goods or services within a specified time to satisfy this obligation. Since themoney for these goods has already been received, this transaction should be somehowrecorded. There are two accounting methods for recording these transactions – liabilitymethod and income method. These two methods differ drastically, and you will find outhow in just a second.
Under the liability method, unearned revenue is recorded as a liability because as it wassaid earlier, the company still owes products or services to the customer. To recordreceipt of advance payment, a company would debit a Cash account and credit anUnearned Revenue account.
Once a portion of the product or service is delivered, an adjusting entry is required. Thiswould include crediting an Income account and debiting the Unearned Revenueaccount, which means that unearned revenue will decrease and move to the income.Adjusting entries will be made until the unearned revenue is fully earned and can beconsidered a profit. However, there’s another reporting method that counts unearnedrevenue as income right away.
A company might also choose an income method for keeping its records. In this case,the advance payment will be considered an income. A journal entry will include a debitto the Unearned Revenue and a credit to the Income account. When the products orservices are provided only partially, the portion of the income that is still not earned willbe credited to the Income account and debited to the Unearned Revenue account.
Accrual accounting implies recording the income and expenses, regardless of themoment of receipt of funds, from the moment of payment for goods (work, services).With this bookkeeping method, income and expenses are recorded from the moment ofaction, delivery of goods, rendering of services.
This is the method that companies are required to adhere to according to the GenerallyAccepted Accounting Principles. This way, all business operations and other facts of financial activity are reflected in the accounts and in financial statements in thosereporting periods in which they were performed.
The accrual method allows bringing closer in time the moment of comparison of costsand revenues, more accurately measure the results of commercial and financialoperations. This means that a company will record advance payment only when itactually produced a good and delivered it to a customer and not when it still has toencounter production expenses. In this case, a liability reporting method will be used.