Unearned revenue refers to funds a seller receives for goods or services not yet delivered to the buyer.
Unearned revenues turn up in many familiar purchase situations.
- When a traveler purchases airline or railroad tickets in advance, for instance, the carrier has unearned revenues until it delivers the service.
- If the purchaser of land or other real estate makes an initial deposit on the property, the seller has unearned revenue on the deposit until the sale transaction completes and legal ownership transfers.
- When magazine or newspaper subscribers pay in advance, the publisher has unearned revenues until the subscription copies are delivered.
Once the purchased goods or services are delivered, the seller is said to have earned the revenues. When this occurs, the seller now recognizes the same funds as revenue earnings in an Income statement account. This explains the reason that unearned revenues are also known as deferred revenues. As a result, the funds classification unearned revenues is a temporary classification.
Explaining Unearned Revenue in Context
The unearned revenue concept is one of several similar concepts made necessary by accrual accounting. Sections below illustrate accrual concepts operating in a double entry accounting system. This article further explains unearned revenue in the context of related terms such as the following:
- What is unearned revenue (deferred revenue)?
- How does accrual accounting recognize revenues?
- Bookkeeping transactions for unearned revenue.
- Explaining relationships between unearned revenues, deferred payments and other accrual concepts.
- Do unearned revenues exist with cash basis accounting?
Most Firms Use Double Entry Systems and Accrual Accounting
Most businesses worldwide implement accrual accounting with a double entry accounting system. They choose this approach even though it is more complex and more difficult to use than the simpler alternative, single entry accounting. Using a double entry system, for instance, requires users to have at least some level of formal training in accounting. The double-entry user must, for instance, have a solid grasp of concepts such as debit, credit, Chart of accounts, and the so-called Accounting equations. By contrast, just about anyone who can arrange numbers in a table and add and subtract can set up and use a single entry system.
Public companies and almost all large firms nevertheless choose double entry and accrual accounting. This is because it is simply impossible for them to meet government reporting and record-keeping requirements using a single-entry system alone. And, they choose this approach because it enables them to track manage revenues and expenses, as well as liabilities, owners equities, and assets. By contrast, Single entry accounting serves only for managing cash outflows and inflows.
Unearned Revenues Help Implement the Matching Concept
The unearned revenue concept serves to help firms turn cash payments into revenue earnings over a period of time. In other words, with accrual accounting, customer prepayments do not become revenue earnings immediately. Regardless of when customers pay cash, revenues do not qualify as revenue earnings until the seller delivers the goods or services.
Unearned revenue serves in this way to apply a universally recognized principle in accrual accounting—the matching concept. "Matching" means:
- Firms report incoming revenues in the period they actually earn them.
- They match revenues by reporting in the same period the expenses they incur to earn them.
In brief, matching means that firms report revenues along with the expenses that brought them. In this way, the matching concept contributes to accuracy in reporting profits.
When Does Accrual Accounting Recognize Revenues?
In accrual accounting, sellers must in fact meet two conditions in order to recognize funds as revenue earnings.
- Sellers must deliver goods and services for the revenues..
- If the sale has been closed but the customer has not yet paid, the seller can claim revenues earned only if seller considers the revenues to be realizable. This means the seller has reasonable expectation that cash payment will actually be received.
In the unearned revenue situation, the second condition has already been met because the customer has already paid. In this situation the seller simply claims revenue earnings when delivery occurs.
When the firm first receives payment as unearned revenues, the bookkeeping journal transactions that follow depend on how long it will take to earn the revenue (complete delivery of goods and services). The important question is whether or not earning occurs in the same period as payment.
Example 1. Recognizing Revenue for Same-Period Earnings
If goods or service delivery will occur in the near term, say, within a month and within the current accounting period, the firm treats the revenues as ordinary revenue earnings.
Consider a $500 purchase that begins with a customer cash payment. As a result, the seller debits an asset account.
- Here, the debit is a $500 increase in the account Cash. At the same time, the seller credits $500 to a revenue account.
- Here, the credit is a $500 increase to the account Product sales revenue.
|Exhibit 1. Journal entries for cash received and product sales revenue earnings.|
Example 2. Recognizing Revenues When Earning Occurs in a Later Period.
However, when it is clear that the revenue earnings will not complete for several months, or until the next accounting period, the journal transactions include a debit to an asset account and a credit to a liability account.
- Here, the debit is a $500 increase to the Cash account.
- And, the credit is a $500 increase to the Unearned revenue account.
These Journal transactions might look like this:
|Exhibit 2. Journal entries when the customer pays cash before the seller delivers goods or services.|
When the seller finally delivers goods or services, later, the firm recognizes revenue earnings with two adjusting entries in the journal:
- Firstly, a debit to the same liability account used earlier. Here, that is a $500 decrease in the Unearned revenue account.
- Secondly, a credit to a revenue account. Here that is a $500 increase in the revenue account Product sales revenues.
These might appear as follows in the bookkeepers journal:
Journal for Fiscal Year 20YY
250 Unearned revenue
|Exhibit 3. Journal entries after both sales transaction events. At this point, the customer has paid cash for the purchase, and the seller has delivered purchased goods and services.|
In practice, the firm makes a second pair of entries— adjusting entries—during the accounting period, as it actually delivers goods and services. Accountants often wait until the until the end of the period to make these entries, when they must report Balance sheet accounts as they stand at period end.
Firms manage unearned revenues with accrual accounting in much the same way they handle some other revenue and expense transactions when there is a time lapse between two parts of a business transaction.
- One part is the buyer payment.
- The other part is the seller's delivery of goods and services.
Both parts may occur simultaneously, as in retail shopping. Or, either part may precede the other with a time lapse between them. For instance:
- Delivery occurs first when the customer buys using credit issued by the seller.
- Payment occurs first when a traveler buys airline tickets on a "fly now, pay later" plan.
Because the matching concept mandates that firms recognize revenues in the same period with the expenses that brought them, prepayment and deferred payment situations present a special challenge to the company's bookkeepers and accountants. This because it is possible for actual payment and actual delivery.
For compliance with the matching concept, both the seller and the buyer record the first part of the sale event, as it occurs, with two journal entries. Example journal entries of this kind appear above in Exhibit 1 and 2. Exhibit 2 represents such entries when there is a time lapse between parts sale parts 1 and 2.
Later, when part 2 of the sale occurs, buyer and seller each make another pair of journal entries, such as those shown in Exhibit 3. The seller cannot claim revenue earnings and the buyer cannot claim expense payments, until both parts of the sale transaction complete.
Exhibit 4 summarizes the possible accounting results from a sale, after just one part of the two-part sale transaction takes place.
Transaction Part One...
|Customer Pays Before Seller Delivers||Seller Delivers Before Customer Pays|
|The Seller Has ..||Unearned Revenue
|The Buyer Has ...||Deferred Expense
|Exhibit 4. Accrual accounting results after only one part of the sale transaction event takes place.The terms in each cell are interchangeable.|
Prepayment: Payment Precedes Delivery of Goods or Services
The prepayment situation occurs when customers pay before receiving goods or services. That is the unearned revenue situation, the subject of this article.
- From the seller's viewpoint
The seller recognizes unearned revenues (or deferred revenues) as revenues received for goods and services that have not yet been delivered.
The seller records unearned revenues as liabilities until delivery of the goods or services. After delivery, the funds become revenue earnings for the seller.
- From the buyer's viewpoint:
The buyer recognizes deferred expenses (or prepaid expenses or deferred charges), when paying for services or goods before delivery.
- An inventory of postage stamps, bought but not yet used, is a prepaid expense.
- When firms pay taxes in advance of due date, they create prepaid expense.
- Buyers record prepaid expenses as assets until they receive the goods or use the services.
- For more on the deferred expense concept, see Deferred Expense.
Deferred Payment: Delivery of Goods or Services Precedes Payment
The deferred payment situation occurs when the seller delivers goods or services before the customer pays.
- From the seller's viewpoint:
In the deferred payment situation, the seller who has not yet been paid records accrued revenues (also called accrued assets or unrealized revenues). These are revenues earned by the seller for delivery of goods and services for which the seller has not yet been paid.
Sellers may post accrued revenues in an asset account, such as Accounts receivable until the customer actually pays cash. Then, the seller credits (reduces) Accounts receivable, while at the same time debiting (increasing) another asset account, Cash.
For more on the accrued revenue concept, see Accrued Revenue.
- From the buyer's viewpoint:
Buyers post accrued expenses, or accrued liabilities in their books, registering their debt for goods and services purchased but not yet paid for.
- When employers owe their employees salaries or wages for work completed, but not paid them yet, the employer has an accrued expense.
- Interest payable for a bank loan can be an accrued expense. Accrued expenses are first entered into the journal as a liability until paid, at which time the liability account is debited (reduced) and an asset account, such as cash, is credited (decreased).
- Firms first enter Accrued expenses
in the journal as liabilities until they pay them.
- Firms debit (reduce) a liability account when they actually pay.
- At the same time, they credit (decrease) an asset account such as Cash.
Exhibit 5, below, shows the results after the second sales transaction event.
|After Both Parts of the Sales
|When Payment Precedes Delivery||When Delivery precedes Payment|
|The Seller Has ..||Sales Revenue earnings||Sales Revenue earnings
|The Buyer Has ...||Expenses paid||Expenses paid|
|Exhibit 5. Accrual accounting results after the second sales transaction event.|
Sections above represent accrual accounting with a double entry system. The vast majority of business firms, worldwide, in fact choose accrual accounting over the simpler alternative, cash-basis accounting. Cash-basis accounting recognizes only two kinds transactions--both representing the flow of cash.
- Expenses are recognized when cash is paid
- Revenues are recognized when cash is received.
Unearned revenues (deferred revenues)—and other prepayment and deferred payment situations in accrual accounting—simply do not exist under cash basis accounting.