Unearned revenue is the revenue received from a customer for which the supplies are not yet supplied or the services not yet performed for which the money is received.
This is the cash received by the seller or the company but they have not yet performed their duties.
This is a liability created for the company for which they have to perform or supply the supplies equal to the value of the cash they have already received.
Unearned revenues are useful for the seller for the cash flow performance because they have already received the cash while no service provided yet.
They can use the cash for other useful activities. Unearned revenue is considered as prepayment by the payer for which they still have to receive the services or goods.
Because of this prepayment, the seller has the liability equal to the unearned revenue or the cash received from the payer.
This liability will be written off when goods or services are supplied to the customer at a value equal to the unearned revenue recognized by the seller.
Nature of unearned revenues:
Because the company has received money for a service that they have not performed yet, it creates a liability for the company. unearned revenues are cash received in advance for the services and therefore possess liability nature.
Unearned revenues cannot be recorded in the revenue account of the income statement because it does not fulfill the criteria of revenue recognition of the international financial reporting standards.
If the services are supplied to the customer on a partial basis, they will recognize only partial revenue while remaining still in the liability account.
Entire unearned revenue liability will be set off against revenue only when the value of services provided is equal to the unearned revenue liability account.
Recognition of unearned revenue:
Unearned revenue is recognized as a liability on the company’s balance sheet. It is recorded as a liability because the company has not yet earned the revenue and they owe products or services to a customer.
When the products or services are delivered over time to customers, they are recognized as revenue gradually in the income statement.
When a company accepts cash for unearned revenue, it increases the cash as well as the current liability account. These are both balance sheet items and hence do not affect the income statement items.
Unearned revenue is recorded as a current liability when the products or services are to be delivered in the next 12 months or lower than 12 months.
However, if the products or services are to be delivered in more than 12 months, it is recognized as a non-current liability.
Accounting double entry in the financial statements of the company:
In the beginning, when the company accepts cash for revenue, it is recognized as a liability with a corresponding entry to increase cash or bank.
It is recognized as a liability account because the company still has to provide services or products to the company at a later date.
Here is the example:
Dr Cash or Bank XXXX
Cr Unearned Revenue XXXX
When the company later gradually delivers the services, a debit entry is made to the current liability account hence decreasing the current liability account as the company has now no liability for that amount of delivery of service.
On the other hand, a credit entry is made to the revenue earned hence increasing the revenue account or revenue figure for the company in the income statement. Delivery of services or products may be partial or in full.
Cr Revenue XXXX
Dr Unearned Revenue XXX
If products or services delivered are partial to the total amount of the whole amount, only a partial amount is debited to the current liability account while crediting the revenue earned account.
Along with that if the products or services delivered are in full, the whole amount of the unearned revenue liability account is debited while crediting the revenue earned account in the income statement.
Recognizing unearned revenue in the revenue account without recognizing it in the current liability will overstate the revenue figures and net profit while understating the current liability accounts. This is against the IFRS 15 of international financial reporting standards.
According to IFRS 15 revenue must only be recognized when the obligations for the products or services are delivered to the customer.
This case of recognizing unearned revenue as revenue is a highly risky area in terms of audit engagements because revenue accounts are of the highest figures in the financial statements in most cases.
Examples of unearned revenues:
Let’s suppose a customer John paid $10,000 in advance to ABC Company for parking for three months. When the company accepts the cash, they will record unearned revenue because the company has not yet provided the services to the customer for now.
The company will debit the cash account while credit the current liability account hence balancing the financial statements. When the ABC Company gradually delivers the service to the customer for parking, they will recognize the unearned revenue in the revenue account.
Upon delivering the obligations, ABC Company will debit the current liability account while crediting the revenue account in the income statement.
Cash received by a legal retainer in advance to the services delivered to customers is another example of unearned revenue. The legal retainer has still had to deliver legal services to the customer.
Prepaid insurance received by the insurance company creates a liability for the insurance company but that is unearned revenue. Prepaid insurance will create an asset account for the customer.
A company cannot immediately recognize the cash proceeds received in advance as revenue because it is against the guidelines of the IFRS 15 which deals with revenue recognition.
According to IFRS 15, they will recognize the revenue gradually when the services are delivered to the customer with the passage of time.
As compared to revenue recognition, they will have to create a liability account for the unearned revenue.
As the services are delivered, revenue will be recognized with the number of services provided while reducing the liability account with the same amount of revenue recognized in the income statement.