How to account for customer's advance payment?

June 21, 2010

1. Revenue recognition principle

Cash and accrual accounting treatment of revenue recognition may be different. Nevertheless, in this article we will look only at the rules for accrual accounting.

Revenue recognition is a somewhat complicated area in accounting due to different sales scenarios. In general, revenue can be recognized in the income statement only when the following two criteria are met:

  • Revenue is realized or realizable, and
  • Revenue is earned

Revenue is realized when a company exchanges goods and services for cash or claims to cash (i.e., receivables).

Revenue is realizable when assets a company receives in exchange are readily convertible to know amounts of cash or claims to cash.

Revenue is earned when a company has substantially accomplished what it must do to be entitled to the benefits represented by the revenues that is, when the earnings process is complete or virtually complete.

If revenue is not realized or realizable and earned, then its recognition should be delayed. In situations when a company receives a payment from a customer and the two criteria mentioned above are not met, then the revenue is deferred and the amount received is treated as unearned revenue. Unearned revenue is recorded on the balance sheet. Once the criteria are met, the company should recognize the unearned revenue as earned (in the income statement).

2. Example of unearned revenue situation

Let us look at an example. A company is the wedding services business. The company received an advance payment of $5,000 from a customer. The wedding services will be provided to this customer during the next quarter. What is the accounting treatment of this transaction?

We should determine if the two criteria have been met. The receipt of cash means the revenue was realized. However, the service has not yet been performed because the wedding services will not take place until the next quarter. As such, the revenue is not earned. As the second criterion has not been satisfied, the $5,000 can't be recognized in the income statement yet. Instead, the company would record the amount as unearned revenue on the balance sheet by making the following entry:

Account Titles

Debit

Credit

Cash

5,000

 

      Unearned Revenue

 

5,000

When the wedding services are provided in the next quarter, the second criterion will be met, and then, the revenue could be recognized in the income statement:

Account Titles

Debit

Credit

Unearned Revenue

5,000

 

      Revenue

 

5,000

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