Unearned revenue is money received by a business for which the goods or services the payment is for have yet to be provided. Sometimes this type of revenue is called deferred revenue or prepaid income; it means the same thing. In accounting, we treat revenue unearned as a liability and disclose it in the statement of financial position.
Before we get into the meat of deferred revenue, we have to mention subscription revenue. Although tied up with what we are talking about in this tutorial, it has a different accounting standard (IFRS 15). If you like guidance on this specifically, please have a look at our tutorial on this here.
Why a Liability?
In our accounting tutorial covering liabilities, we looked at how we define liability. And this was:
“a financial arrangement that creates an obligation on the firm to expend future economic benefits as a result of a past event”.
And unearned revenue fits right into this definition. Let us see how.
When a third party pays in advance, there is an understanding between the parties about what will happen, i.e., an arrangement or contract or agreement. People don’t usually send money off to a business just for the fun of it. As agreed in advance, they expect something to be done for the money they send.
Creates an Obligation
In accounting, the phrase obligation is a fancy way of saying that it now has agreed to do something in return because the business has received something. For the business to be accounting for this unearned revenue under the agreement, as described above, it needs to create a monetary obligation, i.e. it has to be measured in dollars and cents.
Expend Future Economic Benefits
Another unusual phrase is “economic benefits”. All it means is the business has to be giving up something that it values now, in a monetary sense, at a date after it received the money. So for the money, it has received and now has sat in its “hot little hand”, it will have to do work for that. It will have to deliver a good or perform a service, or often a combination of the two.
As a Result of Past Events
The final part requires the obligation on the business to be present now, not sometime in the future. Not to be confused with delivering some goods or services in the future, which we covered in the above subsection of future economic benefits. At the time of preparing the financial accounts, the obligation must be binding to the business.
As a side note: there are times when events take place after the balance date, nowadays called “Events after the Reporting Period”. We use to call them “subsequent events”. Under IAS 10, when an event confirms a condition existing at the balance date, we account for the situation. So long as that subsequent event takes place before the board approves the financial accounts. If I may say, we have a pretty good tutorial on this which you can find here.
Unearned Revenue – Example and Journal Entries
So let’s now turn to an example and see what the standard journal entries are in the accounting for unearned revenue. Our trusty ABC Ltd has its month-end April 20XX accounts to prepare. On 31 March 20XX, it received $20,000 from a client to complete some earth moving work. The client had some spare budget capacity and wanted to use this before year-end, 31 March, and paid ABC Ltd in advance for the job. ABC is planning on doing the work in May.
So how do we account for the money received – the obligation created – and when ABC completes the work? These three distinct events are as follows.
Receipt of Money and Obligation Creation
The journal entry to record the $20,000 received on 31 March would be:
The debit to the bank increases the funds held by ABC Ltd as of 31 March. At the same time, the credit to unearned revenue increases its level of obligations to third parties. In this case, if for some reason ABC was not able to undertake the earthworks itself or subcontract the work, it would have an obligation to return the funds to its client.
Fulfilment of Obligation and Recognition of Revenue
On May 10, ABC completes the works ahead of schedule and on this date makes the following entry:
|10 May||Unearned Revenue||20,000|||
As it has fulfilled its obligation to its client and has no further obligations under this contract, ABC can bring to account the revenue earnings for the work carried out. It reduced the obligation (liability) side with a debit of $20,000 and increased revenue with a credit of $20,000.
You will see that this is the first time the statement of financial performance (income statement) sees this transaction. Up until now, it has all been in the statement of financial position (balance sheet).
On May 10, two events take place to generate the above journal entry. First, the contract no longer meets the definition of liability as we went through above. So it then has to turn into something else. And yes, it then becomes revenue. In our accounting tutorial looking specifically at revenue, we defined this as “… the inflow of economic benefits as a result of past events”. And that is what we see; $20,000 in economic benefits to ABC rather than a customer obligation.
Today has been all about calling a revenue item a liability at the beginning of a contract and then calling it revenue at the end of the contract. Understanding what a liability is and the obligations created under a contract are vital to ensuring the correct accounting for unearned revenue.