Unearned revenues arise from prepayments to a company from customers or clients (consumers). Although, a company may have received cash, they have not performed any services or sold any goods, and, as a result may not recognize any revenue. Thus, these type of transactions defer revenue until a company has earned the right to claim it. When a company receives a prepayment, a liability account titled unearned revenue is credited.
Example 1: Adequate Disclosure, Inc. plans to perform auditing services for its major client, Inadequate Disclosure, Inc. for $200,000. Inadequate Disclosure, Inc. decides to pay its auditing fee before the audit begins. Record the journal entry that Adequate Disclosure, Inc. must record.
A company earns revenue when it actually performs the services or provides the goods it was contracted for. Although, a company has a claim on revenue upon performance, the actual recording of the revenue is postponed until the end of the period when adjustment entries are made. The reason behind this is: efficiency. Thus, at the end of the period, a company records revenue and reduces the liability it has on its books. Before an adjusting entry is made, liabilities are overstated and revenues are understated.
Example 2: Same fact pattern as example 1.
Common Sources of Unearned Revenue:
- Rent
- Customer Deposits
- Subscriptions
- Newspaper
- Magazines