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, not even if the payment for those services is received in advance.
Unearned revenues are reported in financial statements as liabilities in the current liabilities section of the balance sheet. Once the services or products are provided to the customers, these unearned revenues will be reclassified into revenues in the company’s income statement. It is not present in other financial statements.
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 state 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 owes 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 revenue liability in the company’s income statement.
This is because the company has now fulfilled the obligation of delivering services or products, and the company has now earned 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 has not yet delivered the services or products.
A current liability is reclassified to earned revenue when the company fulfills the obligation of delivering services or products. 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 named John wants to subscribe to a one-month music subscription on a website for $20.
When the $20 is 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 music service 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.
The 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