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 bit of a strange balance day adjustment and so we thought it worthwhile to cover, ensuring people are provided with the right 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 then 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 are normally dealing with money, this may not always be the case. And one of the drivers to better financial reporting around the world 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 of those accounts that are to the left of the equals sign (“=”) in the equation are normally 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 key balance day adjustments (or 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. So for example with prepayments, even though cash has moved from the reporting entity to a third party, this creates an asset for the reporting entity rather than an expense on the debit side of the transaction. The asset is created because the reporting entity has an entitlement to economic resources now 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, ie 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 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).
The journal entry ABC’s accounting team would create would depend on how the receipt of cash is initially recognised. If ABC puts the transaction through say its normal sales cash books, like below:
This would create a problem at year-end, being 31 March, as ABC has yet to carry out the work for the government and so although the bank figure of $30,000 is correct, the sales (revenue) is not. The revenue is unearned at balance date. So the accounting team would make the following adjustment:
Traditionally within accounting all balance day adjustments are reversed in the new reporting period, so as to keep the system cleaner and is less hastle 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 is assuming the work is completed by ABC 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, this is 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 to clarify the issue and perhaps a broader appreciation of this balance day adjustment within accrual accounting systems.