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What is Unearned Revenue?
Unearned revenue is a type of liability that is recorded on the balance sheet of a business. It represents an obligation to deliver goods or services in the future, for which payment has already been collected. Unearned revenue is also referred to as a prepayment, deferred revenue, or advanced payments.
Unearned revenue is typically recognized as a current liability on the balance sheet. This is because the obligation to deliver the goods or services is typically expected to be fulfilled within one year or the operating cycle of the business, whichever is longer.
The accrual method of accounting recognizes revenue when it is earned, rather than when cash is received. This means that when a business receives payment for goods or services that have not yet been delivered, the money is recorded as a liability on the balance sheet. This is because the business has an obligation to deliver the goods or services to the customer in the future. Once the goods or services have been delivered or performed, the liability is extinguished and the revenue is recognized. This is because the business has fulfilled its obligation to the customer, and the revenue can be considered earned.
Examples of Unearned Revenue
Unearned revenue is common in any business where payment is collected in advance of the goods or services being delivered. Some of the most common industries and businesses include:
- Landlords collect rent in advance, typically on a monthly basis. This means that the tenant pays rent for a specific time period (such as one month) before actually occupying the property.
- Insurance companies often require payment upfront for the coverage period. For example, a homeowner may pay a lump sum for a one-year insurance policy.
- Legal services firms, such as law firms, often require a retainer fee prior to beginning work for a client. The retainer fee is typically a deposit that is held in trust and used to pay for legal services as they are provided.
- Travel services, such as airlines, cruise lines, and hotels, typically collect payment in advance of providing their services. For example, a customer may purchase a plane ticket or book a hotel room weeks or even months in advance.
- Online retailers generally collect payment in advance of shipping goods to the customer. In this case, the payment is considered unearned revenue until the goods are shipped. This is because the retailer has an obligation to deliver the goods to the customer, but has not yet fulfilled that obligation.
Journal Entries for Unearned Revenue
Unearned revenue is recognized as a current liability on the balance sheet. As the obligation related to the unearned revenue is delivered over time, the liability decreases as the amount is transferred to revenue on the income statement. This process is referred to as deferred revenue recognition.
Journal entry for cash received for services not yet performed
Larry’s Landscaping Inc. has received $500,000 from its customer for landscaping services that it intends to provide next month. Larry’s Landscaping Inc. follows accrual accounting and must recognize unearned revenue.
| Account | ||
|---|---|---|
| Cash | $500,000 | |
| Unearned revenue | $500,000 |
This journal entry reflects the fact that the business has received payment from its customer, but has not yet fulfilled its obligation to provide the landscaping services. As a result, the revenue is considered unearned and is recorded as a liability on the balance sheet.
Journal entry for services performed originally recognized as unearned revenue
Larry’s Landscaping Inc. has provided landscaping services to its customer and satisfied its obligations. Larry’s Landscaping Inc. eliminates the unearned revenue liability and recognizes the $500,000 into revenue.
| Account | ||
|---|---|---|
| Unearned revenue | $500,000 | |
| Service revenue | $500,000 |
This journal entry reflects the fact that the business has fulfilled its obligation to the customer, and the revenue can now be recognized as earned. It also reduces the unearned revenue liability by the same amount, as the business no longer has an outstanding obligation related to this revenue.
