A question we noticed that comes up quite regularly for those new to accounting is, what is the normal balance of unearned revenue? It is a bit of a strange balance day adjustment, so we thought it worthwhile to cover, providing you with the correct information.
The short answer to the question is the unearned revenue’s normal balance is a credit; because it is a liability account. If you would like a fuller explanation, please read on.
Definition of Unearned Revenue
As we mentioned above, unearned revenue has a normal credit balance. It has this because it is a liability account. So what is a liability? Looking at the conceptual framework issued by the International Financial Reporting Standards body, a liability is a financial arrangement that creates an obligation on the reporting entity to transfer economic resources to a third party at a future date.
The term “economic resources” is used in the framework because although we usually deal with money, this may not always be the case. And one of the drivers to better financial reporting worldwide has been to standardise how businesses report to stakeholders.
If we now turn to the accounting equation, this will help us see how this account fits within a reporting entity’s set of accounts. Taking from our tutorial on this topic, we can use the expanded accounting equation, being:
All accounts left of the equals sign (“=”) in the equation usually are debit accounts. While all of those to the right of the equals sign are credit accounts. As our unearned revenue is a liability account, its normal balance is a credit.
So how does unearned revenue arise? How does it get into the books? That is what we will look at next.
Balance Day Adjustments
Unearned revenue forms one of the four essential balance day adjustments (sometimes referred to as adjusting entries). The other three being: accrued revenue (or unbilled revenue), prepayments (or payments in advance); and, accrued expenses. The links are to each of our specific accounting tutorials covering these topics.
Balance day adjustments are required under accrual accounting as this system requires us to measure the economic flows of resources rather than just the movement of cash. For example, if a reporting entity prepays for a service, it would account for an asset rather than an expense. An asset is created because the reporting entity has an entitlement to economic resources for the payment in advance it has made.
And when we look at unearned revenue, the credit doesn’t go to revenue/income, but rather it creates a liability. Because the work for that receipt of cash has yet to be carried out, i.e. the flow of economic resources has yet to arise, there is a future obligation on the reporting entity to expend these resources at some point in the future.
So let’s work through an example with the debits and credits to explain further.
Example of Unearned Revenue
ABC Ltd, a small construction company, signs a contract with a client to carry out some renovation work. The small job is for a government agency, whose budget for the work in the current financial and needs spending now before they lose it in the new budget round. So the agency pays ABC Ltd in advance (hence unearned revenue is also often referred to as revenue in advance).
ABC’s accounting team’s journal entry would depend on how the cash receipt is initially recognised. If ABC puts the transaction through the usual sales cash books, it will look like what we have below.
This would create a problem at year-end, 31 March, as ABC has yet to carry out the government’s work, so although the bank figure of $30,000 is correct, the sales (revenue) is not. The income is unearned at the balance date.
Balance Day Adjustment – Unearned Revenue
So the accounting team would make the following adjustment:
Sales are reduced by the debit entry because there is no revenue to recognise. At the same time, the credit to unearned revenue creates the obligation ABC has to its customer to do the work.
Traditionally within accounting, all balance day adjustments are reversed in the new reporting period to keep the system cleaner and more hassle-free in tracking all those adjustments. So the accounting team would process the reversal of the 31 March entry on 1 April as:
|1 April||Unearned Revenue||$30,000|||
This journal entry assumes ABC complete the work in the next accounting period. If any part of the project is not completed, and the transaction is material in ABC’s reporting, another balance day adjustment may need to be made. Otherwise, the sales are fully reflected in the correct period (although no longer fitting within the conceptual frameworks, ensuring the matching of expenditure and revenue in the correct accounting period).
That brings us to the end of unearned revenue and its normal balance discussion. We trust this helps clarify the issue and perhaps a broader appreciation of this balance day adjustment within accrual accounting systems.