What is unearned (deferred) revenue?

April 11, 2010

1. Nature of unearned (deferred) revenue

Unearned revenue is the collection of cash before a good or service is provided to a client. In some instances, clients may prepay for a good or service to receive a sales discount or to meet the terms of a contractual obligation. Any collections of cash for a good or service not yet provided will be recorded as unearned (deferred) revenue. For a company to recognize the receipt of cash as revenue, it must fully earn that revenue. The receipt of cash alone does not signify that income was earned and can be recognized as such. Since this receipt of cash has not been fully earned, the unearned revenue is recorded as a liability. A liability is typically considered to be an obligation to make a monetary payment in the future, but it can also refer to the future provision of goods or services.

Upon the receipt of unearned revenue, a business still has the obligation to provide the good or service to the client at a specified point in the future. Once the good or service has been "earned" or provided, the unearned revenue is recognized as income. A firm will only record that part of revenue that was actually earned during a specific month or transaction period.

Example 1: XYZ Company has contracted with ABC Company to manage a building owned by ABC. An important aspect of this contractual agreement is that XYZ Company is to initially be paid 6 months of management fees in advance, at $1,000 per month, for a total of $6,000. XYZ Company will collect $6,000 in unearned revenue from ABC Company. As the building management services have not as of yet been provided, the unearned revenue of $6,000 is recorded as a liability on the balance sheet of XYZ. The journal entry to record unearned revenue received from XYZ Company is as follows:

Account Titles

Debit

Credit

Cash

6,000

 

      Unearned ABC Management Fees

 

6,000

Each month that XYZ provides management services to ABC, a portion of unearned revenue will be recognized as revenue. A monthly adjusting entry will transfer the $1,000 monthly fee from unearned to earned revenue:

Account Titles

Debit

Credit

Unearned ABC Management Fees

1,000

 

      ABC Management Fees Earned

 

1,000

Note that the remaining $5,000 in unearned revenue will remain a liability and decline as the contracted services are provided. At the end of the sixth month, the unearned revenue will be zero.

Example 2: The Fox Valley School (FVS) system purchases a library journal system from Rand Journals for $24,000 ($2,000 per month). The contract states that Rand Journals will provide one year of access to the school system. The Fox Valley School system has prepaid in full for this one year service. The journal entries for Rand Journal to record this transaction and subsequent monthly adjustments would be as follows:

To record advance collection of 12 months subscription from FVS:

Account Titles

Debit

Credit

Cash

24,000

 

      Unearned FVS Revenue

 

24,000

To record monthly subscription fees earned:

Account Titles

Debit

Credit

Unearned FVS Revenue

2,000

 

      FVS Subscription Revenue

 

2,000

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