Overview
Unearned or prepaid revenue is a business’s liability even though it has the word revenue in it because you receive payments in advance from a customer for a service that has not yet been started or completed or products that the customer has not yet received. Thus, this type of revenue is initially recorded as a liability. Besides increasing your liabilities, unearned revenue also increases your cash flow because you are receiving cash in advance. Your business can use this cash in your operations. This means that thanks to the unearned revenue, you can cover your expenses and not have to worry about tying up your own money or money you loaned in the making of your product.
You can also use the cash received in the form of unearned to grow your business and invest in new equipment or research new possibilities. When doing so, though, remember that your business does not really owe this money until you fulfill your obligation before the customer. It might happen so that you might need to return the advance payment. An unearned revenue account is also necessary to comply with the matching accounting principle. This principle states that expenses should be matched to the revenue they produce. Thus, you need to recognize revenue only when you incur the expenses, which would happen when you actually provide the service or make the product. To do so, you would move the money from the Unearned revenue account to the Revenue account when the customers get what they paid for. Recognizing all revenue at once while recognizing the expenses associated with it in later periods would mean a violation of this important accounting principle.
Examples
There are numerous examples of prepaid revenue that you might come across. Although nowadays most businesses deliver the product or service before the payment is actually made, many businesses require customers to make payments in advance. The most common business spheres that have unearned revenue in their accounting books are rental agencies where clients have to make a deposit before they can, for example, use a product or live in a house as well as businesses that provide services or products on a subscription basis.
Customers can be paying in advance to receive a newspaper, scientific journals, software, bookkeeping, consulting, or any other services. For example, an attorney might receive legal fees before the work is done. People also usually pay for tickets before they attend the event, take a bus or train, etc.
Journalizing
The Sparkle Clean Company agrees to provide office cleaning services to a customer. The monthly charge is $800. The customer pays $4,800 in advance on January 1st for 6 months of cleaning services. The Sparkle Clean Company prepares financial statements on a quarterly basis, so they would prepare the reports on March 31st. On January 1st, the company received cash in the amount of $4,800. It also acquired a service liability equal to the same amount because it did not earn anything. After all, cash does not indicate that we earned something. DateAccountDR CRJanuary 1stCash$4,800 Unearned Service Revenue$4,800Three months later, the company updates its records and recognizes that some of the liabilities have been settled. The Sparkle Clean Company has already provided three months’ worth of services, so it can reduce its liability account by the appropriate amount. DateAccountDR CRMarch 31stUnearned Service Revenue$2,400 Service Revenue$2,400
