Unearned revenue, also called deferred revenue is the advance payments received by a company for products or services that will be delivered at a future date.
Unearned revenue represents a liability account because it is revenue not yet earned because the company still owes the products or services to their customers.
When the products and services are delivered over time gradually, the company will recognize the unearned revenue in the revenue account in the income statement.
Unearned revenue is still to be recognized as revenue because the company has not yet completed the obligations of providing the services.
International financial reporting on revenue recognition:
IFRS 15 ‘Revenue from Contracts with Customers’ sets 5 principles to determine and complete before revenue is recognized in the income statement. The company recognizing revenue must make sure to complete the following five steps
1) Identify contracts with the customer:
A company making a transaction with the customer and recognizing the revenue must identify the terms and conditions in the contract.
The contract must be agreed with both the parties, services, and goods must be identified, payment terms must be identified, the contract must have a commercial substance, and it is probable that the money will be received which in unearned revenue case is already collected.
2) Identify the performance obligations in the contract:
The contract should identify the performance obligations that the company has to fulfill. These identify the products or services that the company has to deliver to the customer.
3) Determine the transaction price:
The contract between both parties has to determine the transaction price for the goods or services the company has to deliver to the company. These prices should be fair and at arm’s length.
4) Allocate the transaction prices to its relative performance obligations:
When a contract possesses many performance obligations, such as there are many products and services to deliver to the company, each performance obligation should be allocated to its own unique transaction prices.
If the transaction prices are not directly able to be allocated to performance obligations, they should be allocated on a fair estimation.
5) Recognize revenue when the entity satisfies the performance obligation:
The company finally recognize the revenue when they will deliver the services and goods to the customer. Delivery of goods means that the control over them is transferred to the customer.
They have to transfer the complete control to the customer and the customer should have the right to consume all the benefits from the goods.
If the services or goods are transferred gradually over time, they have to recognize the revenue to the extent to which the services or goods are transferred to the other party.
Recognition of unearned revenue as revenue in the income statement is limited to the completeness of performance obligations either over time or at once.
The fact is that; unearned revenue is revenue that is not yet earned because the company has not yet played its part in delivering the services or goods to the company.