Businesses are complex systems made up of many components that all need to work together to succeed. With no marketing, sales won’t be made, and without staff, a product won’t be developed, etc. Business relationships can be challenging to track and evaluate. However, carefully evaluating financial data and reports allows business owners and stakeholders to better monitor these relationships.
Companies usually keep two reports on money management: accounting and finance. Accounting reports are sent to tax authorities when necessary, and financial accounting helps a company evaluate their economic situation and make informed decisions. The owner of a company often creates financial statements independently or with the financial manager. So, what does unearned revenue mean and what role does it play in these financial reports and business in general?
Unearned Revenue Definition
Many businesses require customers to pay for products or services in advance. Unearned revenue is income received from such advanced payments. In short, it is income that hasn’t been earned yet, such as rent paid for the upcoming month or payments for products that will be shipped later. Unearned revenue is also often referred to as “advances from customers.”
Doing business this way allows a company to secure a sale while reducing the risk that customers will change their mind about a product. This is especially helpful if the customer is purchasing something that is custom made, or if the product or service requires acquisition of additional supplies, talents or materials to fulfill the order. The customer, in turn, can secure a product or service at a specific price.
How to Calculate Unearned Revenue
It is pretty simple to calculate how much unearned revenue a company has, especially if the company adheres to the Generally Accepted Accounting Principles (GAAP) and uses a liability reporting method. By 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 on the balance sheet under liabilities, until the company has fulfilled its obligations to the customer. 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 be used for this. The sales invoice or the purchase order will not only provide the amount that was paid but also the number of months the payment is made over. Adjusting entries will indicate how much has been earned at the moment of calculation/preparation of a report.
For example, an office has paid $1,000 for lawn care services that will be provided throughout the year. At the end of the first quarter, the company prepares reports, and since the lawn care provider has only performed a portion of their agreed services, there will be entries adjusted for the first three months totaling $250. The unearned revenue will amount to $750. In the adjusting entry, the unearned revenue account will be debited for $250, which will decrease it, and the credit to sales revenue account for the same amount will increase earned revenue and record the income.
Unearned Revenue on Balance Sheet
To make sound management decisions, business owners and managers need relevant information. It is useful for them to see the business as a whole, so they can evaluate and understand all the details. The balance sheet serves that purpose. The balance sheet summarizes all the assets of the company – what it owns, its liabilities, as well as where its funds come from. Assets can come from inside of the company, i.e. equipment and goods in stock, or from outside the company, i.e. investments.
One of the most frequent questions asked about unearned revenue is, “Is unearned revenue a current liability on a balance sheet?” Unearned income on a company balance sheet is usually treated as a current liability, and is expected to be credited to the income account during the relevant reporting period. However, let’s review the answer in detail.
First, one needs to understand what a current liability is. A current liability is the amount of debt owed to creditors or suppliers. This lasts during the normal operating cycle or is repaid within 12 months, depending on the nature of the business. Thus, one can consider unearned revenue a current liability if the company will earn it within one year or within the current operating cycle, whichever is longer.
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 or when a service or product is partially or fully delivered.
Reporting and Bookkeeping Methods
Unearned revenue is a current liability, as previously stated, and denotes an obligation to provide either goods or services within a specified time. Since the money for these goods has already been received, the transaction must be recorded. There are two accounting methods for recording these transactions – the liability method and income method.
Liability Method
Under the liability method, unearned revenue is recorded as a liability as products/services are still owed. To record receipt of an 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 will include crediting an income account and debiting the unearned revenue account, which means that unearned revenue will decrease and move to income. Adjusting entries will be made until the unearned revenue is fully earned and can be considered profit.
Income Method
In this case, the advance payment will be considered as 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 only partially provided, 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
Accrual accounting implies recording all income and expenses, regardless of when the funds were received. With this bookkeeping method, income and expenses are recorded from the moment of action, delivery of goods, or the rendering of services.
This is the method that companies must adhere to according to the GAAP. This way, all business operations and other facts of financial activity are reflected in the accounts and financial statements in the reporting periods in which they were performed.
The accrual method allows a company to record advance payment only when it has actually produced a good and delivered it to a customer. If the company anticipates dealing with production issues in order to deliver goods or services to a customer, a liability method should be used.
