Unearned revenue (deferred revenue) refers to funds received by a seller for goods or services not yet delivered to the buyer.
The following situations are good examples of deferred revenue:
1. When an individual makes an initial deposit as downpayment towards purchasing a land, the seller has recognized unearned revenue upon this deposit, its only when the land title is transferred to the buyer and sale transaction is complete, the seller shall recognize it as Earned Revenue.
2. In case of an airline and railroad, the passenger purchases the ticket in advance of the travel, here the service provider will recognize it as earned revenue once the transportation is delivered. In the AMR Corp. case, this was found on the liabilities side of the balance sheet, under AIR TRAFFIC LIABILITIES (Unearned Revenue).
In accrual accounting, 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.
The journal entry transaction are as follows:
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:
Dr. Cash (+A) 500
Cr. Sales revenue (IS, +RE) 500
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 is as below:
Dr. Cash (+A) 500
Cr. Unearned Revenue (+L) 500
The process is complete, when the goods and services have finally been delivered:
Dr. Unearned Revenues (-L) 500
Cr. Sales Revenue (IS, +RE) 500
Prepayment and deferred payment situations
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.
Prepayments (payment precedes delivery of goods or services)
- From the seller’s viewpoint : The seller will recognize unearned revenue as revenues received for goods and services that have not yet been delivered. Unearned revenues are recorded as liabilities until the product or service has been delivered.
- From the buyer’s viewpoint: The buyer recognizes it as prepaid expenses, when paying for services or goods before delivery. Examples would be prepaid insurance or prepaid rent.
Deferred Payments (delivery of goods or services precedes payment)
- From the seller’s viewpoint: Unrealized revenues are revenues earned by the seller and are posted on the asset account, as accounts receivable, until the payments are actually received.
- From the buyer’s viewpoint: Accrued Expenses are posted in the balance sheet as a liability, for goods and services purchased and received but not yet paid for.
For cash basis accounting system, 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 with other prepayment and deferred payment situations described above, are used in accrual accounting but not cash basis accounting.
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