Unearned revenue is prepaid revenue. In essence, the customer pays in advance for services that have not yet been performed. Unearned revenue is a liability, so the initial entry is a debit to the Cash account and a credit to the Unearned Revenue account.
As the company earns the revenue, it reduces the balance in the Unearned Revenue account (with a debit) and increases the balance in the Revenue account (with a credit). The Unearned Revenue account is usually classified as a current liability on the balance sheet.
If a company were not to deal with unearned revenue in this manner, and instead recognize it all at once, revenues and profits would initially be overstated, and then understated for the additional periods during which the revenues and profits should have been recognized.
Examples of unearned revenue are:
- A rent payment made in advance
- A services contract paid in advance
- A legal retainer paid in advance
- Prepaid insurance
For example, ABC International hires Western Plowing to plow its parking lot, and pays $10,000 in advance, so that Western will give the company first plowing priority throughout the winter months. At the time of payment, Western has not yet earned the revenue, so it records all $10,000 in an Unearned Revenue account, using this entry:
|Unearned revenue (liability)||10,000|
Western expects to be plowing for ABC for a period of five months, so it elects to recognize $2,000 of the unearned revenue per month in each of the five months. In the first of the five months, Western records the following entry:
|Plowing revenue (revenue)||2,000|
A variation on the revenue recognition approach noted in the preceding example is to recognize unearned revenue when there is evidence of actual usage. For example, Western Plowing might have instead elected to recognize the unearned revenue based on the assumption that it will plow for ABC 20 times over the course of the winter. Thus, if it plows five times during the first month of the winter, it could reasonably justify recognizing 25% of the unearned revenue (calculated as 5/20). This approach can be more precise than straight line recognition, but it relies upon the accuracy of the baseline number of units that are expected to be consumed (which may be incorrect).
Unearned revenue is also known as prepaid revenue.