What Is Unearned Revenue?
Unearned revenue is an account in financial accounting, recognized as a liability, which signifies an amount a business owes. Categorized as a current liability, it appears on a company’s balance sheet, which is a fundamental financial statement in accounting. Small businesses encounter unearned revenue when a client pays for goods or services before they have been delivered or performed. This type of revenue is also known as “prepaid revenue.”
Examples of Unearned Revenue
- Service contract paid in advance
- Legal retainer paid in advance
- Advance rent payment
- Prepaid insurance
Unearned Revenue in the Books
When the business fulfills the delivery of goods or performs the agreed-upon services, the unearned revenue account is debited to reduce its balance, while the revenue account is credited to reflect the earned revenue. Recording unearned revenue as an asset instead of a liability would result in an inflated profit for that accounting period. Conversely, this would cause the accounting period when the revenue is actually earned to display a lower profit than it should. Additionally, failing to record revenue in the same period as the associated expenses goes against the matching principle of accounting, which requires that revenues and expenses related to a particular project be recorded in the same period.
The Importance of Unearned Revenue
Unearned revenue is advantageous for a small business’s cash flow, as it ensures immediate access to cash necessary for covering future project-related expenses. Properly managing unearned revenue in accordance with accounting principles helps maintain accurate financial records, providing small businesses with not only a clear financial picture but also compliance with accounting standards.
What Is an Unearned Revenue Example?
Example #1
A client purchases a dog walking package in advance. The package covers three months of walks, priced at $400 per month, totaling $1,200. The client pays the $1,200 upfront. The business owner records this transaction by debiting $1,200 to cash and crediting $1,200 to unearned revenue. The owner then decides to recognize the earned revenue on a monthly basis through an adjusting journal entry. At the end of each month, the owner debits $400 from unearned revenue and credits $400 to revenue. This process is repeated monthly until the full $1,200 has been accounted for as earned revenue over the three-month period.
Example #2
A client buys a package of 20 personal training sessions for $2,000, paying $100 per session, in advance. The client pays the entire $2,000 upfront. The personal trainer records this by debiting $2,000 to cash and crediting $2,000 to unearned revenue. Since the client does not attend regular training sessions, after two months, she has completed five of the 20 pre-paid sessions. This equates to 25% of the total package. Consequently, the trainer can recognize 25% of the unearned revenue, amounting to $500. The trainer does this by debiting $500 from unearned revenue and crediting $500 to revenue.
What Is the Journal Entry for Unearned Revenue?
Unearned revenue is recorded in the books using a double-entry bookkeeping method. Initially, the business debits the cash account and credits the unearned revenue account by the same amount.
This entry reflects the receipt of cash for services or goods not yet provided, signifying that the business has earned cash on credit. Once the business completes the delivery of goods or services, an adjusting entry is necessary. This involves debiting the unearned revenue account and crediting the revenue account for the corresponding amount.
For instance, let’s take the example of a contractor who quotes a client $1,000 to retile a shower. The client pays a $500 prepayment before any work begins. The contractor enters this transaction by debiting $500 to the cash account and crediting $500 to the unearned revenue account.
As the contractor completes half of the job, they need to adjust the entry to reflect the earned revenue by debiting the unearned revenue account $500 and crediting the service revenues account $500. In essence, two journal entries are made for unearned revenue: one when it is received and another when it is earned.
What Is Unearned Revenue vs. Deferred Revenue?
Unearned revenue and deferred revenue are two interchangeable terms that describe the same financial concept: money received in advance for goods or services that have not yet been delivered or completed. Also known as deferred income, these advances from customers are recorded as liabilities on the company’s balance sheet until the corresponding goods or services are provided. This treatment ensures that revenue is recognized in the correct accounting period, in line with established accounting principles.
Conclusion
Understanding and managing unearned revenue is crucial for small businesses to ensure accurate financial reporting and compliance with accounting standards. By properly categorizing unearned revenue as a liability and recognizing it as revenue only when goods or services are provided, businesses can maintain a clear and truthful picture of their financial health. This practice not only upholds the principle of matching revenue with associated expenses but also supports effective cash flow management, enabling businesses to fund ongoing operations efficiently. Correctly handling unearned revenue thus lays a solid foundation for reliable financial statements and long-term financial stability.
