In accrual accounting, revenue recognition can become complicated, especially when companies sell subscription services or complete projects in installments. This is known as unearned revenue or deferred income accounting. There may be instances when payment is collected, before revenue can be recognized. In these situations, unearned revenue must be reported to remain compliant with U.S. Generally Accepted Accounting Principles.
Definition of Unearned Revenue
Unearned revenues occur when companies follow the accrual basis of accounting. When advance payments are received for products or services that will be delivered or completed in the future, the earnings process is not complete. As such, unearned revenue must be recorded.
Unearned Revenue Tracking
Unearned revenue, or deferred revenue as it is often referred to, is tracked using supporting schedules that are either in Excel or a part of the general ledger accounting system. Amortization of the unearned revenue, and the subsequent recognition of regular revenue, is an important part of the month-end-close process.
Examples of Unearned Revenue Transactions
When a company collects a subscription payment that applies to future periods, unearned revenue will be recorded and amortized on a monthly basis. For example, if one pays for a gym membership one year in advance, the gym will make a journal entry for 11 months of unearned revenue and recognize that revenue monthly, over the course of a year. Other examples include advance rent payments, homeowner association assessments and cloud software payments.
Accrual Accounting & Revenue Recognition
The matching principle is a critical concept in accrual accounting to ensure accurate financial statements and dictates that revenue be recognized in the period it’s earned. That is why an unearned revenue account is utilized. Advance payments are recorded as unearned and are recognized in subsequent accounting periods. Revenue recognition is important for remaining in compliance with US GAAP.
Why is Unearned Revenue a Liability?
When prepayment is collected for a product or service, even though the product or service has neither been delivered or performed, so unearned revenue needs to be recorded. The money shows up as a liability on the balance sheet, because the company has possession of money that it hasn’t earned. Over time as the product or service is delivered to the customer, the revenue is recognized on the income statement. The business is obligated to give the money back, if the product is not delivered or the service is never performed.
Revenue recognition and reporting is of critical importance in accounting, especially when there is the potential for unearned revenue. The accuracy of accrual basis in financial statements, especially the balance sheet, and also tax returns, hinges on the proper classification of my monies received and reported as income. Consulting with an experienced accountant is the best option, for determining accounting revenue treatments.