Business is a complex system with many components. An entrepreneur manages sales, develops a product, sets up marketing, and manages employees. Parts of the system are interconnected – there will be no sales without marketing; without staff, there is no one to develop the product. Business relationships can be challenging to track and evaluate. But they are all reflected in finances – the heart of a business that helps move it 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, and financial accounting helps to see the real situation with money in business and make decisions. Often the owner draws up financial statements independently or together with the financial manager. What role does unearned revenue play in these financial reports and 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. What does unearned revenue mean? 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 the company adheres to the Generally Accepted Accounting Principles and uses a liability reporting 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 the company still must perform a service or provide a product. The first step in the calculation is confirming the amount of money received in advance. A check, a sales invoice, or a purchase order can all be used for this. The sales invoice or the purchase order will not only tell the amount that was paid but also the number of months for which the payment is made. Adjusting entries will indicate how much has been earned at the moment of calculation/preparation of a report.
For example, an office paid $1,000 for lawn care services that will be provided throughout the year. At the end of the first quarter, a company prepares reports, and since they provided only a portion of the services, there will be adjusting entries for the first 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 to increase 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 the details. For this purpose, there is a balance sheet. The balance sheet summarizes all the assets of the company – what it owns and liabilities – resources of funds for its operations. That is, on the one hand, this is equipment, raw materials, and goods in stock, and on the other hand, loans, investments from outside and retained earnings.
One of the most frequent questions asked about unearned revenue is “Is unearned revenue a current liability on a balance sheet? Unearned income in a company balance sheet is usually treated as a current liability, and it is anticipated that it will subsequently 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 amount of debt to the creditors or suppliers, which lasts during the normal operating cycle or is repaid within 12 months from the date the balance sheet of the company is prepared. In other words, a current liability is due within a year.
Thus, one can consider unearned revenue a current liability if the company will earn it within 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 customers expect to collect within a year.
Now, let’s figure out why unearned revenue is considered a liability. As it was already mentioned in the definition, unearned revenue is income that is already received but not yet earned. In other words, this means that the company has not however performed a service 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 what journal entries will be made when the payment is received and when a service or product is partially or fully delivered.
Reporting and Bookkeeping Methods
As you just learned, unearned revenue is a current liability, an obligation to provide either goods or services within a specified time to satisfy this obligation. Since the money for these goods has already been received, this transaction should be somehow recorded. There are two accounting methods for recording these transactions – liability method and income method. These two methods differ drastically, and you will find out how in just a second.
Under the liability method, unearned revenue is recorded as a liability because as it was said earlier, the company still owes products or services to the customer. To record receipt of advance payment, a company would debit a Cash account and credit an unearned Revenue account.
Once a portion of the product or service is delivered, an adjusting entry is required. This would include crediting an Income account and debiting the Unearned Revenue account, 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 be considered a profit. However, there’s another reporting method that counts unearned revenue 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 debit to the Unearned Revenue and a credit to the Income account. When the products or services are provided only partially, the portion of the income that is still not earned will be credited to the Income account and debited to the Unearned Revenue account.
Accrual accounting implies recording the income and expenses, regardless of the moment 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 of action, delivery of goods, rendering of services.
This is the method that companies are required to adhere to according to the Generally Accepted Accounting Principles. This way, all business operations and other facts of financial activity are reflected in the accounts and in financial statements in those reporting periods in which they were performed.
The accrual method allows bringing closer in time the moment of comparison of costs and revenues, more accurately measure the results of commercial and financial operations. This means that a company will record advance payment only when it actually produced a good and delivered it to a customer and not when it still has to encounter production expenses. In this case, a liability reporting method will be used.