On the contrary to what the names suggest, unearned revenue and deferred revenue are both the same thing. They are both incomes for which the cash has been collected but the obligations of delivering goods as well as services are yet to be performed.
This concept arises from the accrual basis of accounting, which requires companies to report revenue immediately when it’s earned, and records expense immediately when it’s incurred, regardless of the cash coming in or going out.
Similarly, the generally accepted accounting principles (GAAP) have introduced to us the matching principle. It requires a business to report revenue in the same period the expenses to generate such income are incurred.
It means that if a customer purchases a book from you on 27th December 2018, but pays for it on 2nd January 2019, the sale will be considered done on 27th December, regardless of the payment coming in January of the next accounting period.
This is because, the materials used to produce the book were purchased in 2018 and not 2019 (matching principle), and the rights of the books were transferred to the customer in 2018 too, considering the sale to be made on credit.
Financial Accounting and Reporting for Deferred Revenue:
Unearned revenue or deferred revenue is considered a liability account for a company. Because the money is received even before the services or goods are performed or delivered, the amount is classified as a liability. The journal entry to report unearned or deferred revenue in the books of a company is as follows:
Cash DR xx
Unearned Revenue CR xx
Unearned revenue usually occurs in subscription-based trading or service industries where payments are taken in advance and services are performed later.
Since the GAAP requires us to book revenue as soon as it is earned, the revenue is proportionately recorded according to the work done throughout the contract period until the final good or service is delivered.
When a portion of the deferred revenue is earned, the deferred revenue account is lessened by a debit of the same amount whereas the revenue account is credited.
Unearned Revenue DR xx
Revenue CR xx
There are several examples of unearned revenue such as, payments received for annual subscriptions, prepaid rental income, annual payments for software, and prepaid insurance.
For example, you receive $600 for an annual subscription of magazines at the beginning of your accounting period. You have received, in cash, the entire $600 but have not yet delivered a single magazine to the customer. Your accountant will book the following entry at the beginning of the year:
Cash DR $600
Unearned Revenue CR $600
As the year progresses, you deliver the magazine every month throughout the year. Every month, for every magazine you deliver, you will record an entry recognizing the revenue and lessening the unearned revenue account as follows:
Unearned Revenue DR $50
Revenue CR $50
By the end of the fiscal year, you will have delivered all 12 magazines for the year, and the balance on your deferred revenue account will amount to zero. Simultaneously, each month $50 will be recognized and reported on your income statement.