Unearned revenues are money received against a particular service or obligation that has to be performed in the near future i.e. within 12 months usually.
In simpler words, these are advance payments received in the current period for services to be provided in the future.
For example, company A signs a contract with company B in 2019 to provide management services in June 2020 for $1000. Company A charges an advance payment of 20% of the total amount at the time of the contract.
The $200 (1000 x 20%) would be treated as an unearned revenue and hence a liability because it has been received before any services were provided to company A.
Unearned revenues are recorded in the income statement as income received at the time it was incurred i.e. when the services against it are provided irrespective of the time the payment was received.
Whereas unearned revenues are treated as liabilities in the balance sheet at the time they are received.
For the public and shareholders to understand all the transactions whether cash or non-cash, businesses are required to make financial statements annually including the statement of cash flow to be prepared in accordance with IAS 07.
Statement of Cash flow:
A statement of cash flow is a financial statement that is presented to the Board of Directors at the Annual General Meeting along with the income statement and balance sheet of the company.
It is prepared as per IAS 07 and exhibits all the cash transactions occurred throughout the period and is basically made as per the cash basis of accounting whereas the income statement and balance sheet are prepared according to the accrual basis of accounting. It is presented and organized in the following manner:
- Cash flow from Operating Activities
- Cash flow from Investing Activities
- Cash flow from Financing Activities
The cash flow from operating activities includes all the transactions relating to the main business activities.
In simpler words, it includes adjustment of working capital changes and other items reported on the income statement.
Effect of unearned revenue on statement of cash flow:
An increase in unearned revenue increases the cash flow whereas a decrease in unearned revenue decreases the cash flow.
As we discussed above, unearned revenue is an advance payment received irrespective of the obligations being performed.
As per the matching principle of accounting, every business must record its expenses in the income statement when the revenue from such expense has been derived or generated.
In order to keep a track of the cash received against the unearned revenue, it is recorded in the cash flow statement when the cash is received, in the balance sheet as a liability and in the income statement gradually over time when the obligations are performed.
In 2019 unearned revenue account had a balance of $6500 whereas in 2018 it amounted to $4000.
This means that in 2019 there has been a cash inflow of $2500 as unearned revenue which had no impact on the income statement and has been recorded as a current liability in the balance sheet.
The difference of $2500 ($6500 – $4000) shall be reported in the cash flow statement under the operating activities section in order to get net cash flow from operating activities.
In 2020 the unearned revenue balance reduced from the opening balance of $6500 to $5500. There has been a decrease in the amount of unearned revenue.
This implies that $1000 has been incurred and charged to the income statement in 2020 but no cash or cash-equivalent against this has been received in 2020 since it was received in a prior period.
The $1000 is included in the net profit and in order to get the net cash flow, the $1000 should be deducted in the operating activities section of the statement of cash flow.