Unearned revenue is money received by a business for which the goods and / 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 make a note about subscription revenue. Although tied up with what we are talking about in this tutorial it does have its own accounting standard (IFRS 15) dealing with how this needs to be accounted for. 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 a liability. And this was:
“a financial arrangement that creates an obligation on the firm to expend future economic benefits as a results of a past event”.
And unearned revenue fits right into this definition. Lets see how.
When money is received in advance from a third party it is because there is an understanding between the parties about what is going to happen, ie there is an arrangement or contract or agreement. People don’t normally send money off to a business just for the fun of it. For the money they send they expect something to be done, which is agreed in advance.
Creates an Obligation
A fancy phrase for saying because the business has received something it now has agreed to do something in return. For the business to be accounting for this unearned revenue under the agreement, as described above, needs to create a monetary obligation; ie has to be able to be measured in dollars and cents.
Expend Future Economic Benefits
Another unusual phrase “economic benefits”. All it means is the business has to be giving up something that it values now, in a monetary sense, sometime at a date or dates after the money was received. So for the money it has received and now has sitting 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 is needing the obligation on the business to be present now; not sometime in the future. Not to be confused with delivering some good or services in the future, that is covered under in the above subsection of future economic benefits. At the time of reporting the obligation, or the agreement in place, must be binding to the business at that time.
As a side note there: there are times when events take place after balance date, now days called “Events after the Reporting Period”. We use to call them “subsequent events”. Under IAS 10 when we have an event take place that confirms condition which existed at balance date these do need to be accounted for, as along as that subsequent event takes place before the financial accounts are approved by the board. We have, if I may say, quite a good tutorial on this which you can find here.
Unearned Revenue – Example and Journal Entries
So lets now turn to an example and see what the normal 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 for some earth moving work to be completed. The client had some spare budget capacity and wanted to use this before year-end, 31 March, and so paid ABC Ltd in advance for the work. The work us planned to be carried out in the month of May.
So how do we account for the money received received, obligation created and for when the work is completed? 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 bank increases the amount of bank funds held by ABC Ltd as at 31 March. While 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 earth works itself or subcontract the work out, it would have an obligation to return the funds to its client.
Fulfillment of Obligation and Recognition of Revenue
On May 10 ABC completes the works ahead of schedule and 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 to the client 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 increases 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 account 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 now see; the $20,000 is an economic benefit to ABC rather than an obligation to do something for a third party.
Today has been all about calling a revenue item a liability at the beginning of a contract and then to call it revenue at the end of the contract. Understanding what a liability is and the obligations created under a contact are key to ensuring the correct accounting for unearned revenue.