Unearned revenue / Deferred revenue
Encyclopedia of Business Terms and Methods, ISBN 978-1-929500-10-9. Copyright © 2012 by Marty J.Schmidt. Revised 31 January 2012.
The Meaning of Unearned Revenue (Deferred Revenue)
Unearned revenue (deferred revenue) refers to funds received by a seller for goods or services not yet delivered to the buyer. For example,
- When the purchaser of land or other real estate makes an intial deposit on the property, the seller has unearned revenue on the deposit until the sale transaction is completed and legal ownership is transferred.
- When airline or railroad tickets bought and paid for in advance of travel, the carrier has unearned revenues until the transportation is delivered.
- Magazine or newspaper subscriptions paid in advance are unearned revenues (deferred revenues) for the publisher, until the subscription copies are delivered.
Once they are delivered (i.e., once the seller is said to have earned the revenues), the same funds can be recognized as earned revenues in an income statement account, as shown below. The funds classification as unearned revenues is thus temporary.
In accrual accounting (used by most companies), revenues are recognized as earned when two conditions are satisfied:
- The revenues are earned. This means the goods and services for the revenues have been delivered, and
- Revenue are realized (or realizable). There is a reasonable expectation that that cash will be received.
When unearned revenues are first received, the bookkeeping journal transactions that follow depend on how long it will take to earn the revenue (complete delivery of goods and services).
- If the revenue will be earned in the near term, say, within a month and within the current accounting period, the revenues may be treated as ordinary earned revenue, in which case the journal transactions are the same as for ordinary revenue. In that case there is a debit to an asset account (here, a $500 increase in cash, an asset account), as well as a $500 credit to a revenue account (here, a $500 increase to the account product sales revenue).
Grande Corporation Date Account Debit Credit |
- However, when it is clear that the revenue will not be fully earned for several months, or until the next accounting period, the journal transactions include a debit to an asset account (in the example below, an increase of $500 to the cash account) along with a credit to a liability account (here, an increase of $500 to unearned revenue). Journal transactions might look like this:
Grande Corporation Date Account Debit Credit |
For the latter situation, when the goods and services have finally been delivered, later, the revenues are recognized as earned revenues with two adjusting entries in the journal: a debit to the same liability account used earlier (here, a $500 decrease to the unearned revenue account), and a credit to a revenue account (here, $500 increase in the revenue account, product sales revenues).
Grande Corporation Date Account Debit Credit |
In practice, the second pair of entries—the adjusting entries—may be made during the accounting period, as goods and services are actually delivered, but often they are made at the end of the period, when the balance sheet accounts are reported as they stand at period end.
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Prepayment and Deferred Payment Situations
Unearned revenues (deferred revenues) are handled in accrual accounting in much the same way some other revenue and expense transactions are handled when there is a time lapse between two parts of a business transaction.
Accrual accounting incorporates the matching concept, the idea that revenues should be recognized in the same period with the expenses that brought them. Prepayment and deferred payment situations present a special challenge to the company's bookkeepers and accountants, because it is possible for actual payment and actual delivery to fall in different accounting periods. In order to avoid violating the matching concept, bookkeepers make an initial two entries to register the first transaction event, and then, later, makes adjusting entries to register the second transaction event. For examples of journal entries for each kind of event, see the encyclopedia entries for individual terms, linked below.
Prepayments (payment precedes delivery of goods or services)
- From the seller's viewpoint (the subject of this encyclopedia entry): The seller will recognize unearned revenues (or deferred revenues) as revenues received for goods and services that have not yet been delivered. Unearned revenues are recorded as liabilities until such time as the goods and services are delivered, after which they may be recognized as earned revenues.
- From the buyer's viewpoint: The buyer recognizes deferred expenses (or prepaid expenses or deferred charges), when paying for services or goods before delivery. An inventory of postage stamps, bought but not yet used, is a prepaid expense. When taxes are paid in advance of due date, a prepaid expense is created. Prepaid expenses are recorded as a current asset until the services or goods are delivered or used.
Deferred Payments (delivery of goods or services precedes payment)
- From the seller's viewpoint: Accrued revenues (also called accrued assets or unrealized revenues) are revenues earned by the seller (for delivery of goods and services but which the seller has not yet received. Accrued revenues may be posted in one asset account, such as accounts receivable, until the revenues are actually received. Then, the accounts receivable account (an asset account) is credited (reduced) while the another asset account, cash, is debited (increased).
- From the buyer's viewpoint: Accrued expenses, or accrued liabilities are posted in the buyer's books as a liability, for goods and services purchased and received but not yet paid for. When workers are owed salaries or wages for work completed, but not yet paid for, the employer has an accrued expense. Interest payable for a bank loan can be an accrued expense. Accrued expenses are first entered in the journal as a liability until paid, at which time the liability account is debited (reduced) and an asset account, such as cash, is credited (decreased).
For any company on a cash basis accounting system, however, the bookkeeping practice is much simpler. In cash basis accounting:
- Expenses are recognized when cash is paid
- Revenues are recognized when cash is received.
Unearned revenues (deferred revenues) along with the other prepayment and deferred payment situations described above, are used in accrual accounting but not cash basis accounting.
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