HOW TO PREPARE PRO FORMA FINANCIAL STATEMENTS STEP BY STEP?

Pro forma financial statements are projected financial statements that are produced using several presumptions or projections.

The business preparing the pro forma financial statements make some presumptions and prepare projected financial statements based on those presumptions.

For example, the business might prepare pro forma financial statements to see the impact of possible litigation on the business.

Since pro forma financial statements are based on certain projections and presumptions, the accuracy and reliability of the financial statements must be ensured.

Any presumptions made in the preparation of these financial statements must be disclosed clearly.

Once initial pro forma financial statements are prepared, they must constantly be updated from time to time to reflect the most accurate information.

Pro Forma Financial Statements Uses

Pro forma financial statements have many uses. Some of the uses of pro forma financial statements are as follows.

Planning and Control

Pro forma financial statements can be used to estimate future sales and budgets. These can be used as a planning tool to set standards for the future operations and activities of the business.

Once standards are established, these financial statements can be used to monitor and control actual performance according to the set standards.

This can be achieved by using different tools such as ratio analysis and variance analysis.

Financial Modeling

Pro forma financial statements can also be used to make a summary of all the incomes and expenses of a business.

The financial models are based on presumptions made by the business. Financial modeling is a great decision-making tool.

These models can be used to estimate the income and costs of a business or a project that the business is undertaking.

Reporting

Some businesses such as public listed companies may be required by legislation or standards to prepare pro forma financial statements.

For example, businesses may be required to report any effects of changes in the accounting policies of the business using pro forma financial statements.

Furthermore, pro forma financial statements can be used as a reporting tool to the stakeholders of the company, for instance, the owner, potential investors, creditors, etc.

Pro Forma Financial Statements

There are three main financial statements that are prepared based on presumptions and projections. These are the balance sheet, the income statement and the cash flow statement.

The pro forma financial statements should all be prepared in conjunction with each other.

The presumptions used for the preparation of these financial statements must be consistently applied to all financial statements.

Pro Forma Income Statement

When preparing pro forma financial statements, the pro forma income statement should be prepared first because the other two pro forma financial statements rely on figures from the pro forma income statement.

The pro forma income statement is based on the most recent income statement of the business, which is usually the financial statements of the last period.

Once the most recent income statement of the business is available, the pro forma income statement can be prepared using the following steps:

  1. A percentage should be determined to use to add or subtract to the recent income statement figures to forecast future figures. This percentage is based on the presumptions a business makes. For example, if the business expects its revenues to increase by 20% next year, this should be the percentage used to inflate all other items of the pro forma income statement as well.
  2. Once a percentage is determined, it should be applied to both the revenues and cost of goods sold of the business in its last income statement. By doing this, the business will ensure that a consistent rate is applied to all the variable expenses.
    So, according to the previous example, if the business determines that its sales will increase by 20%, it is highly likely that the cost of sales will raise by the same percentage. The predicted gross profit should then be calculated by subtracting the project cost of goods sold from the projected revenues.
  3. For operating expenses, every item should be evaluated individually. If the business determines that the rent expense will increase in the period for which the pro forma income statement is prepared, then it should increase the expense accordingly. Similarly, if the business is looking forward to cutting down any expenses in the future, then the expenses should be adjusted in the pro forma income statement.
  4. Once the operating expenses are adjusted, the net profit of the business can be calculated. This net profit should then be multiplied with the expected tax rate for the period for which the pro forma income statement is prepared to calculate the estimated tax expense. Once an estimate tax expense is determined, the net profit after tax should be calculated.

Once the pro forma income statement is prepared, the figures are then taken to the pro forma balance sheet.

Pro Forma Balance Sheet

Since the preparation of the balance sheet depends on figures obtained from the income statement, the pro forma balance sheet is the next pro forma financial statement to be prepared.

The step by step method to prepare a pro forma balance sheet is as follows:

  1. The net profit after tax figure should be transferred from the pro forma income statement and adjusted in the retained earning balance on the balance sheet.
  2. Based on the adjustments in the pro forma income statement, other balances in the pro forma balance sheet should also be adjusted. For example, if the business based its pro forma income statement on 20% expected increase in its revenues, then it is highly likely that the debtor balances of the business will also go up. Similarly, the cost of goods sold will also increase in line with the increase in the revenues of the business, thus, resulting in higher creditor and inventory balances.
  3. Once the balances related to the figures in the pro forma income statement are adjusted, the remaining balances should be evaluated individually for any expected changes. For example, if the business expects to purchase a fixed asset during the period for which the pro forma financial statements are prepared, then the fixed asset balances are adjusted accordingly. Similarly, all other asset, equity and liability balances should be evaluated.

Once the pro forma balance sheet is prepared, the pro forma cash flow statement can be prepared.

Pro Forma Cash Flow Statement

When preparing pro forma financial statements, the pro forma cash flow statement is prepared at last.

This is because the cash flow statement relies on figures from both the pro forma income statement and the pro forma balance sheet.

The pro forma cash flow statement can be prepared using either the direct method of cash flow statement preparation or the indirect method. The steps to prepare them are as follows:

Direct Method

  1. For the direct method of pro forma cash flow statement preparation, the most recent cash and cash equivalent balances of the business should be taken. These balances should be taken from the same financial statements that the pro forma income statement is based on.
  2. Any expected receipts of cash should be added to the cash and cash equivalent balances. These expected receipts should be in line with the expected fluctuations in the pro forma income statement and any expected changes in the debtor and inventory balances of the business. Any expected receipts from other sources should also be added to the balances.
  3. Any expected payments of cash should be subtracted from the cash and cash equivalent balances. Like the receipts, these payments should be in line with the fluctuations in the cost of goods sold and operating expenses in the pro forma income statement. They should further be adjusted for any expected changes in the inventory and creditor balances in the pro forma balance sheet. Furthermore, any special payments, for example, purchase of a fixed asset, should also be adjusted in the payments.
  4. Finally, the net movement in the cash and cash equivalent balances should be calculated and added to the opening cash and cash equivalent balances taken in step 1 to arrive at the closing cash and cash equivalent balances.

Indirect Method

  1. For the indirect method of pro forma cash flow statement preparation, the net profit before taxation figure should be taken from the pro forma income statement. Any non-cash expenses, such as depreciation and amortization, should be added back to the amount.
  2. Any cash flows from operating activities should be adjusted against the net profit before taxation figure. These may include changes in current assets and current liabilities balances such as debtor balances, inventory balances and creditor balances.
  3. Any cash flows from investing activities should be adjusted against the net profit before taxation figure. These may include any cash inflows or outflows from investing activities of the business such as purchase of fixed assets or investments made.
  4. Any cash flows from financing activities should be adjusted against the net profit before taxation figure. These may include cash inflows from receipt of equity or debt finance or outflows for payment of long-term debt obligations.
  5. Finally, the net movement in the cash and cash equivalent balances should be calculated and added to the opening cash and cash equivalent balances to arrive at the closing cash and cash equivalent balances of the business. This opening cash and cash equivalent balance is taken from the most recent financial statements of the business.

The closing cash and cash equivalent calculated using both methods should be equal to the cash and cash equivalent balances in the pro forma balance sheet.

Conclusion

Pro forma financial statements are forecasted financial statements of a business based on certain presumptions or projections.

Pro forma financial statements are used for many purposes such as planning and control, financial modeling or reporting.

There are three main pro forma financial statements that businesses prepare. These are the pro forma income statement, balance sheet and cash flow statement.

The pro forma income statement is prepared first, followed by the pro forma balance sheet and finally, the pro forma cash flow statement.

INCOME STATEMENT PRESENT BY NATURE

The income statement of a business, also known as the statement of profit or loss. It is among the five key financial statements for businesses. The other four are the balance sheet (also known as the statement of financial position), the statement of owners’ equity (also known as the statement of changes in equity), the cash flow statement (also known as the statement of cash flows) and the Notes to the financial statements.

Each of the key financial statements of business gives different information about the business. The Balance Sheet of the Business shows the financial position of a business at any time.

It represents the total assets, owners’ equity (or shareholders’ equity), and total liabilities of a business.

The statement of owners’ equity gives information about the changes in the capital of owners of the business and any profits or losses of the business.

The cash flows statement gives an overview of the cash position and movements during the period of the business. Notes to the Financial Statements give extra information about the business and the other financial statements.

The financial statement that gives the main information about the performance of the business is the Income Statement.

The company could has option to income statement either using nature or by function template.

In this article, we will discuss about preparation of income statement using nature template.

But, before moving the detail of this, let talk about the key information that income statement show to the user first.

Income Statement

The Income Statement of a business, also referred to as Statement of Financial Performance, is the main indicator of the performance of a business.

The Income Statement is used by the owners and any other stakeholders of the business to determine whether the business is profitable or not.

The performance of a business in its Income Statement is demonstrated by two key figures. The Gross Profit and the Net Profit.

The Income Statement of the business is prepared for a specified period. It is prepared either quarterly, semi-annually or annually.

Unlike the Balance Sheet and Statement of Owners’ Equity of a business, the Income Statement does not carry over any balances from previous years or carry forward any balances to next year’s Income Statement.

The Net Profit (or Loss) calculated in the Income Statement is carried over to the Accumulated Profits (or Losses) in the Equity portion of the Balance Sheet of the business.

1) Gross Profit

The Gross Profit of the business is the profit that the business makes purely due to its business operations.

It is the profit that the business makes on the sale of goods or services without taking into account any additional overheads. Therefore, the Gross Profit is a key indicator of the performance of the business.

To calculate the Gross Profit of a business, its total production expenses are subtracted from its total revenues for the specified period.

The production expenses of the business are all expenses of the business that are directly attributable to the generated revenues of the business for that period. This is also known as the Cost of Sales or Cost of Goods Sold of the business.

The Gross Profit of a business can be calculated using the formula below:

Gross Profit = Revenue – Cost of Sales (or Cost of Goods Sold) In the Income Statement of a business, the gross profit is often presented as following:

2) Net Profit

The Net Profit is the overall profit of the business. This is calculated by taking all the expenses of the business and subtracting them from the revenues for the period. The Net Profit shows the overall profitability of the business.

The Net Profit of a business can be calculated using the following formula:

Net Profit = Revenues – All expenses (Cost of Sales + Other Expenses)

The Net Profit of a business is calculated after the Gross Profit of the business is calculated. Therefore, the Net Profit of a business can also be calculated using the following formula:

Net Profit = Gross Profit – Other Expenses (All expenses – Cost of Sales) The Net Profit of a business is presented as following in the Income Statement of the business:

3) Expenses

The expenses of a business must be calculated after every specified period to calculate the Gross Profit and Net Profit of the business.

The types of expenses incurred in business differ according to the nature of the business. For example, machinery repair expenses will not be borne by a services-based business like schools.

When presenting expenses in the Income Statement of a business, they are generally grouped together. This is because a typical business can have many types of expenses.

This is done to present a better Income Statement for stakeholders to easily understand. For example, all expenses related to labor costs may be grouped together under one heading “Salaries”.

When it comes to grouping together expenses, there are two methods to choose from for businesses. Businesses may choose to group together their expenses in the Income Statement either by the nature of the expense or the function of the expenses.

Presenting Expenses in Income Statement

The financial statements of a business are prepared to satisfy the needs of different stakeholders for information regarding the activities of the business.

These stakeholders may range from the owners of the business, who are the main stakeholders of any business, to the management, employees, customers, or suppliers of the business. The stakeholders of a business may also include the government or the general public.

To satisfy the needs of these stakeholders, information about the business is provided in the form of financial statements.

The stakeholders then use the information provided in these financial statements to make different decisions about the business. For example, the owners of the business may use the information to make decisions about further investments in the business.

Since a variety of stakeholders make decisions based on the information provided in the financial statements of the business, it is important that the information is provided in an understandable way.

That is why standards exist to provide guidelines about how the information should be presented.

When it comes to expenses in the Income Statement, the standard dictates that expenses should be grouped together.

Furthermore, it dictates that these expenses should be grouped either by the nature of the expenses or their function.

The standard does not specify which method should be used by businesses but rather gives them the option to choose based on the business’ management decision.

The standard dictates that the management can choose any method they deem will provide the most reliable and relevant information to the business’ stakeholders.

The management of the business also take other factors into mind when deciding on which method to use.

These include the historical factors of the business, industrial factors of the industry the business operates in, and the nature of the business itself.

Presentation by Nature

Grouping expenses and presenting by nature isn’t common practice among businesses globally. However, in some European countries such as France, it is common to present expenses in the Income Statement of business by their nature.

For example, instead of presenting expenses as Cost of Sales, Administrative Expenses, Marketing Expenses, etc. (presentation by function), they are presented as Utilities, Repair and Maintenance, Depreciation, Salaries, etc.

Presenting expenses by their nature eliminates any judgement on the management’s part. In functional presentation, expenses that are not attributable to a specific function are split and apportioned based on the judgement of the management.

This judgment can easily be manipulated by the management to show better performance in certain areas of the business.

For example, since Depreciation is no longer presented by function, the need to apportion it to different functions is eliminated.

The presentation of expenses by their nature is also easier to prepare for businesses. Therefore, many small businesses prefer this method over the functional presentation of expenses as it is cost beneficial.

This presentation is also the basis for the preparation of single-step income statements. In the single-step income statement, instead of calculating Gross Profit and Net Profit, all expenses are subtracted from the revenues of the business directly to reach the Net Profit of the business.

This presentation can also have many other uses for businesses. For example, presenting and grouping expenses by their nature can be useful forecasting future cashflows of the business.

Example

A business, ABC Ltd. has generated revenues of $2 million for the year ending 2019. It’s expenses, by nature are as follows:

The tax expense calculated by the management of ABC Ltd. is $35,000.

The Income Statement of ABC Ltd. can be prepared as follows:

Conclusion

Income Statement is one of the five key financial statements for businesses. The Income Statement of a business is an indicator of the financial performance of the business for a period.

This performance is demonstrated in the form of calculation of profit of the business in the Income Statement.

The profit of the business is calculated by subtracting the expenses of the business from its revenues for a period.

The expenses in Income Statement can be presented by their nature or their function. Unlike functional representation, the natural presentation of expenses does not require expenses to be allocated and apportioned between different functions.

INCOME STATEMENT PRESENT BY FUNCTION

Any business has 5 main financial statements. These are the Balance Sheet (Statement of Financial Position), the Income Statement (Statement of Profit or Loss), the Statement of Owner’s Equity (also known as the Statement of Changes in Equity), the Cash Flow Statement (Statement of Cash Flows) and the Notes to the Financial Statements.

These key financial statements are required to be produced by businesses under the financial reporting standards, although, sometimes exemptions may apply.

The income statement is one of the most important financial reports that show the users a key entity’s financial performance for a period of time including sales revenue, cost of goods sold, gross profits, administrative expenses, interest expense, tax expenses, etc.

Entity has the option to prepare its income statement in either by present it in the form as function or nature.

In this article, we will discuss the presentation or preparation of income statement by function.

Before we discuss the detail of the income statement by function, let us discuss what is the income statement and what is the information that the income statement shows to the users.

Income Statement (Statement of Profit or Loss)

The Income Statement of a business shows the financial performance of a business for a period, usually produced quarterly, semi-annually, or annually.

The Income Statement of a business shows the owners and other important users how the business has performed in its activities for that period. This performance is judged through two key figures, the Gross Profit and the Net Profit.

The Income Statement of a business takes all the expenses of the business and subtracts them from the revenues and other incomes of the business for the period to reach the profits of the business.

When only expenses that are directly attributable to the revenues of the business, also known as the Cost of Sales, are subtracted from the revenues, the profit calculated is known as the Gross Profit of the business.

When all the expenses of the business are subtracted from the revenues of the business, it is known as the Net Profit of the business.

Gross Profit

The Gross Profit of the business is the total profit after deducting all the expenses directly related to the revenues of the business from its revenues. The formula to calculate the Gross Profit of a business can be written as:

Gross Profit = Revenues – Cost of Sales

Net Profit

The net profit of the business is the total profit after deducting all expenses, whether they are directly attributable to the revenues of the business or not, from the revenues of the business. The formula to calculate the Net Profit of a business can be written as:

Net Profit = Revenues – All Expenses (Cost of Sales + Other expenses)

The Net Profit of a business can also be calculated using the Gross Profit of the business. Instead of deducting all expenses of the business from the revenues of the business, all expenses that are not directly attributable to the revenues of the business (All expenses less Cost of Sales) are subtracted from the Gross Profit.

This can be written as:

Net Profit = Gross Profit – Other Expenses (Expenses that are not Cost of Sales)

Expenses

As demonstrated above, the expenses of the business must be deducted from its revenues to reach its Gross Profit and Net Profit. Businesses have different size of expenses.

For smaller businesses, these expenses are usually in thousands while for bigger business these expenses can be in millions. Furthermore, businesses may have various types of expenses.

example, all businesses have salary expenses for their employees, repair and maintenance expenses, depreciation expenses, utilities expenses, etc. All of these expenses are aggregated at the end of the year and subtracted from the revenues of the business to reach its profits for the year.

The above expenses are classified by their nature. These expenses can also be grouped together based on the function of the business where the expenses occur. When grouped by the function of the expense, the presentation is known as functional presentation.

Presenting Expenses in the Income Statement

The main reason a business prepares financial statements is to report its activities for a period or at a specific period to its stakeholders.

The main stakeholders of any business are its owners. Other stakeholders may include the business’ management, employees, customers, suppliers, government or the general public.

These financial statements are prepared for the stakeholders to provide them with useful information on the basis of which they can make decisions.

For instance, the owners of the business use the financial statements of the business to make decisions regarding their investments in the business. The management might use financial statements to develop strategies for the business, etc.

While some of a business’ stakeholders may have financial knowledge to interpret the data provided in the financial statements of the business, the majority of stakeholders do not.

It is, therefore, the duty of the management of the business to present data in the financial statements of the business in a way that it is relevant and understandable by the stakeholders.

For the Income Statement of the business, this is achieved by presenting the expense of the business in one of two ways, as required by the standard.

The expenses of the business can either be presented by their function or by their nature.

The choice to choose either lies with the management of the business. According to the standard, the management can choose among the two options based on reliability and relevance of the presentation.

The management of a business usually take different factors when choosing between the two presentations. These factors may include, but are not limited to, historical and industrial factors and the nature of the business.

Presentation by Function

Most businesses around the world choose the option to present expenses in their Income Statements by their function.

However, the standard requires that if the expenses of the business are presented by their function in the Income Statement, the Notes to the Financial Statements should provide information about the nature of these expenses.

For nonprofit organizations, the standards dictate that expenses must be presented by their function. These expenses are reported in the Statement of Functional Expenses and Statement of Activities, two unique Financial Statements in nonprofit organizations.

These expenses are presented by their functions, usually Program Costs and Operating Costs. A breakup of the functional expenses by their nature is then provided in the Statement of Functional Expenses of the organization.

When expenses of a business are presented by their function, they are grouped together according to the activity of the business where the expenses are incurred.

Expenses that can be directly associated with a function are allocated to the function without any further calculations. However, some expenses may have to be apportioned according to the proportion of the function they are incurred in.

For example, the depreciation of a building used by the business can be split into different activities and apportioned to the related functions, such as administrative, marketing, production, etc.

Once apportioned, they are grouped together and presented in the Income Statement of the business.

This presentation of expenses allows businesses to easily calculate the Gross Profit and Net Profit for the period. This is because expenses are split according to the function of the business and, therefore, expenses directly attributable to the revenues of the business can easily be identified from other expenses.

As a minimum, this presentation requires the Cost of Sales of the business to be separately presented from other expenses of the business. This is due to the Cost of Sales being the main element necessary to calculate the Gross Profit of the business.

Furthermore, as expenses are grouped together by their function, businesses can easily trace any business functions with high expenses. This allows businesses to better control expenses by allowing them to narrow the expense down to the activity where the expense is being incurred in.

This also allows businesses to easily make budgets and check for any variances in those budgets with actual data because budgets are usually made departmentally.

This method can be easier to understand for the stakeholders of the business as this presentation is widely used.

However, the management of the business might need to make some judgements to apportion expenses to different functions.

For example, as mentioned above, depreciation may need to be apportioned between different functions. This apportionment is usually based on judgement.

Example

A business ABC Ltd. has revenues of $2 million in the year 2019. The expenses, directly attributable to the functions are as follows:

Production Expenses
Expense Type$
Raw material consumed                                            1,200,000
Production staff salaries                                                  80,000
Machinery repair and maintenance                                                  10,000
Total                                             1,290,000
Administrative Expenses
Expense Type$
Administrative staff salaries                                                  50,000
Legal charges                                                  10,000
Insurance                                                  20,000
Total                                                  80,000
Marketing Expenses
Expense Type$
Marketing staff salaries                                                  50,000
Advertisements                                                  15,000
Total                                                  65,000

The following are expenses that are have to be apportioned to each function:

Depreciation ($)
ProductionAdministrativeMarketingTotal
                              120,000                                80,000                                50,000                              250,000
Utilities ($)
ProductionAdministrativeMarketingTotal
                                60,000                                12,000                                   8,000                                80,000

ABC Ltd. also calculated tax expenses for the year as $35,000.

The Income Statement of the business can be presented functionally as follows:

ABC Ltd.
Income Statement
For the year ended 2019
$
Revenues                                            2,000,000
Less: Cost of Sales                                          (1,470,000)
Gross Profit                                                530,000
Administrative Expenses                                              (172,000)
Marketing Expenses                                              (123,000)
Tax                                                (35,000)
Net Profit                                                200,000

Conclusion

The Income Statement of a business shows the Gross Profit and Net Profit of the business. These are calculated by subtracting the expenses of the business from the revenues of the business.

These expenses can be either presented according to their function or nature. When expenses are presented according to their function, any expenses directly attributable to the function is allocated directly to the function.

Any expenses that cannot be directly attributable to the function are apportioned to different functions based on judgment.

What Is The Difference Between Share Capital and Liabilities?

Introduction:

The balance sheet also known as the statement of financial position is one of the annual financial reports that exhibit the financial position of a company as at the year-ended.

Share capital and liabilities are both line items of the balance sheet. The statement of financial position is based on the accounting equation, which is also referred to as the balance sheet equation for obvious reasons. The accounting equation is:

ASSETS = LIABILITIES + EQUITY

Share Capital:

For small entities, share capital is the owner’s contribution to the business i.e. the amount that the owner has invested in the business.

However, for large organizations, share capital is a part of equity which is raised by issuing shares. It refers to the amount or cash funded by potential investors, who later, after investing, become partial owners of the company.

The share capital is divided into several shares at par value, and each share represents ownership. The funds raised by equity financing are typically used to expand the business.

There are two major types of share capital:

Common Stock – Common or ordinary shareholders are the sole owners of the company and have voting rights at board meetings.

They receive dividends but only when the company earns a profit. In case of liquidation, ordinary shareholders are given the last preference i.e. they receive their share of liquidation profit after paying off all the other stakeholders of the company.

Preference Stock – Preference shareholders may or may not have voting rights. They receive fixed dividends, regardless of the company earning profits. In case of liquidation, preference shareholders have a senior hand over the net assets than the ordinary shareholders.

Liabilities:

Liabilities of a company are the cash or amount that it has borrowed from other entities. These are obligations that the company has to perform in the near or later future. Liabilities are classified into two major types on the balance sheet; current liabilities and non-current liabilities.

Current Liabilities – These are short term debts that are to be paid off within a period of 12 months. Accounts payable, interest payable, and rent payable are a few examples of current liabilities.

Non-current Liabilities – These are debts that are to be paid off in the long run i.e. more than a year; for example, a bank loan.

Share Capital vs Liabilities:

Share capital and liabilities are both methods of acquiring cash to provide for the business, but are obtained in extremely different ways.

  • Share capital is the owners’ contribution or the funds raised by issuance of shares whereas liabilities are the amounts owed by the company to other entities.
  • Money raised through the issuance of share capital is owned by the company, whereas money obtained through credit or loan is the money of the lender that has to be returned along with interest.
  • Shareholders receive dividends whereas lenders receive interest. Also, usually in case of current liabilities, no interest is charged.
  • In case of liquidation, creditors are paid off from the net assets before the shareholders.
  • Shares can be sold and transferred whereas liabilities can not be sold and transferred.

Unearned revenue vs unearned income

Unearned Revenue:

Unearned revenue is the money received by an individual or a company for services that have yet to be provided, or goods that are yet to be delivered. This is a prepayment from the buyer for goods and services to be supplied at a later date.

This would count as a liability for the seller, as the revenue has yet to be earned because the good or service hasn’t been delivered. It is recorded as a liability on a company’s balance sheet.

Companies that have subscription-based products or services have to record unearned revenue. Receiving prepayments can be beneficial for a company that has to purchase inventory or pay interest on debt.

Some examples of unearned revenue are rent payments, prepaid insurance, airline tickets, gift cards, and subscriptions for channels or newspapers.

When the company provides a good or service and hence “earns” the revenue, they debit the unearned revenue account to reduce its balance and credit the revenue account to increase its balance. The unearned revenue is usually a current liability.

If a company didn’t classify the unearned revenue as a liability and instead recognized it as profit or revenue, it would overstate the profit in the income statement and when the service or good is actually provided, the profits would be understated for that time period.

This goes against the matching principle since revenues are being recognized without the related expenses being recognized.

Unearned Income:

Unearned income is the income received from investments or other sources that are unrelated to employment. Unearned income is income that is not gained through employment, work, or business activities; hence it is different from earned income.

Earned income includes wages, salaries, tips, and self-employment income. Before retirement, unearned income can be an addition to earned income but after retirement, it is often the only source of income.

Taxation is different for earned and unearned income both.

Interest and dividends are the most common types of unearned income. Interest income earned on savings deposit accounts and loans is taxed as ordinary income. Dividends are income from investments and are taxed at ordinary rates or preferred long-term capital gains tax rates.

Some of the common sources of unearned income are the following:

  • Professional fees earned by an individual or commercial enterprise.
  • Tips earned in the services sector
  • Wages earned on the job
  • Self-employment income, which is recorded tax-wise, on an IRS 1099 form.
  • Commissions earned on the job, usually in the sales sector.
  • Bonuses earned on the job, like a Wall Street broker earns for meeting or exceeding company sales/revenue expectations, for example.
  • Sick leave on the job (yes, getting the flu has a financial impact, according to the IRS.
  • Personal time-off pay is taken by employees.
  • Long-term disability benefits again garnered from full or part-time employment.
  • Meal, transportation, and accommodation reimbursement from employees traveling on the company dime.
  • Non-cash income earned on the job, such as a vehicle provided to a traveling salesperson by his or her company.

Conclusion:

Unearned revenue is a liability for companies and individuals whereas unearned income serves as a supplement to normal earned income for companies and individuals.

Unearned Revenue vs Unbilled Revenue

Unearned Revenue:

Unearned revenue is the money received by an individual or a company for services or goods that haven’t been supplied or provided yet. This counts as a prepayment for the buyer for goods and services that need to be supplied at a later date.

Unearned revenue would is recognized as a liability for the seller, as the revenue is not yet earned because the good or service hasn’t been delivered. It has to be recorded as a liability on a company’s balance sheet.

Businesses that have subscription-based products or services have to record unearned revenue as it is the way their business is structured.

Receiving prepayments can be advantageous for a company that has to purchase inventory beforehand or pay interest on the debt. Some examples of unearned revenue are rent payments, prepaid insurance, airline tickets, gift cards, and subscriptions for channels or newspapers.

When a company provides the good or service and hence has “earned” the revenue, they have to debit the unearned revenue account in order to reduce its balance and credit the revenue account in order to increase its balance.

The unearned revenue is usually a current liability unless prepayment has been received for the supply of goods or services after a year.

If a company fails to classify the unearned revenue as a liability and instead recognized it as profit or revenue, they are overstating the profit in the income statement and when the service or good is actually provided, the profits would be understated for that time period.

This will go against the matching principle because revenues have to be recognized in the period they were earned, along with expenses that related to that period.

Unbilled Revenue:

Unbilled revenue is revenue that has been earned by a company or individual but not yet recorded on their accounts. Or it is recognized revenue that has been accounted for but no invoices have yet been sent to the customer.

It basically means that the service or good has been provided to the customer but you have not yet billed them. You could say it goes hand in hand with unearned revenue.

When you receive a prepayment from a customer, it is recognized as unearned revenue and since the customer hasn’t been billed an invoice for the good or service, it is unbilled revenue as well.

So to account for unbilled revenues, companies should include a section in their balance sheets for unbilled receivables to recognize revenue for a given period and should count unbilled receivables toward their total revenue even if an invoice has not been generated or sent to the customer.

Unbilled revenue could be treated in two ways depending on the accounting principle the company is adopting, either accrual basis concepts or cash basis.

If they were recording on accrual basis concept then they would have to debit the Account Receivables to decrease its balance and credit the Income or Sales Revenue account to increase its balance.

While it’s necessary for some businesses to establish relationships through unbilled revenue, minimizing the need for such situations can provide a much clearer idea of your total revenue.