Lesson Objectives:- Definition of unearned revenue
- How to perform an adjusting entry for unearned revenue
- The revenue recognition principle
The third type of adjusting entries, unearned revenue is often considered the hardest to understand because it can be tricky to determine when to report revenue.
You can think of unearned revenue as prepayment for products or services that the company is expected to provide to the customer. Unearned revenue is considered a liability because the seller is liable for that amount of revenue until the obligation is fulfilled. Instead of owing money, the company owes the product or service.
Unearned revenue is not recorded on the income statement as it as not yet been earned. When the revenue is actually earned, it can then be recorded as income.
Now that we've talked about what unearned revenue is, let's look at a real-world example of unearned revenue and look at how the adjusting entry is recorded.
We will review a common example of a company selling a magazine subscription. The subscription costs $120 for 12 months of magazine shipments.
The journal entry for this example would read that $120 cash is received and the company is liable for the $120 of unearned revenue. The way that this would be recorded is that the cash would be debited by $120 to show that the asset of cash is increased. The unearned revenue liability is credited because it is also increased.
We've now recorded the initial cash receipt journal entry, now let's look at how the adjusting entry is performed.
Since the company is shipping the magazines on a monthly basis, each month they will be decreasing their amount of liability while increasing the amount of revenue they've earned.
The revenue recognition principle states that the income must be earned by the company before it can be recorded as revenue. Until the service is provided, the unearned revenue is considered a liability. In this example, the company must ship the magazines in order to fulfill the magazine subscription. Each month that they ship the magazine, they will earn that portion of the $120.
Since the revenue cannot be recorded upfront, we will need to use an adjusting entry to record the revenue recognition over time. In this case, when the first magazine is shipped the liability of unearned revenue is decreased by one month's worth of magazine shipments. Instead of being liable for 12 magazines, the company would now be liable for 11. To equate this to a dollar amount, we would divide the $120 by the 12 months subscription which would be $10 per magazine, then subtract the $10 to come up with a new unearned revenue amount of $110.
When the company is preparing their financials at the end of the month, they would debit the unearned revenue for $10 and credit the revenue for $10. This will reflect the passage of one month of magazine shipments.
Let's summarize how the unearned revenue adjusting entry stays in compliance with the adjusting entry rules.
This example of unearned revenue has the following characteristics that follow the three rules for adjusting entries:
The adjusting entry reflects the revenue of the company.
Cash is not involved in the transaction.
Shows that 1 month passed and revenue was earned over that time period.
In the next lesson, we will talk about the final type of adjusting entry: accrued revenue.