Unearned revenue sometimes referred to as deferred revenue is the payment received in advance for the products or services that will be delivered at some point in the future.
Unearned revenue is based on accrual accounting in which the revenue is recognized only when the products or services are delivered to the customer no even if the payment for those services is received in advance.
Unearned revenues are classified as liabilities in the current liabilities section of the balance sheet. Unearned revenues are more common in insurance companies and subscription-based service providers. These payments in advance are recognized as current liabilities.
Classification of Unearned Revenue:
Accounting principles such as International accounting standards and International Financial Reporting Standards states that unearned revenue is a liability account for a company that has received payment in advance but the company has not completed the work or has not delivered the goods yet.
It is because the company still owe the products or services to the customer. If the company fails to deliver the services or products to the customer or the contract is finished between both parties, the company will have to pay the money back to the customer.
Because of the payment to the customer back, which the company owes to the customer, unearned revenue is recognized as a current liability.
However, when the products or services are delivered to the customer, the company will reclassify the current liability in revenue in the income statement of the company.
This is because the company has now fulfilled the obligation of delivering services or products and the company has now earned the unearned revenue.
How is unearned revenue classified into revenue?
Unearned revenue needs reclassification after it is earned. Initially, when the company receives the money from the customer as a prepayment, it recognizes a liability because the company has received the money but not yet delivered the services or products.
When the company completes the obligation of delivering services or products, current liability is reclassified to revenue earned. In this case, the current liability account is finished and transferred to revenue by the following accounting double entry.
Dr_Current Liability (Unearned Revenue) xxxx
Example of reclassification of unearned revenue:
Let’s assume a person John wants to subscribe to the one-month subscription of music on a website for $20.
When the $20 are prepaid to the website owners, they will recognize a current liability of $20. Website owners will perform the following accounting double entry
Cr_Current Liability (Unearned Revenue) $20
When one month passes, the company will reclassify the current liability to revenue earned. This is because The website owners have now completed the obligation of providing a one-month service of music to the customer.
The company will transfer the amount from current liability to revenue earned by debiting the current liability and crediting the revenue earned in the income statements. T
he company will perform the following accounting double entry to reclassify the current liability into revenue earned.
Dr_Current Liability (Unearned Revenue) $20
Cr_Revenue earned $20