Unearned Revenue Explained
Many businesses receive revenue before they actually provide a good or service. This is called unearned revenue; it is classified as a liability until the good or service is produced. The revenue is transferred from the unearned revenue to the earned revenue account (i.e. sales revenue) once the product or service has been delivered to the customer.
For example, XYZ Company sells insurance, and their customers routinely pre-pay for 12 months of insurance at a time. When XYZ receives the money, it is recorded as unearned revenue because the revenue has not been earned yet. Another example is ABC Pallet Company, which makes wooden pallets for shipping. A customer pays them $25,000 for 1,000 pallets to be delivered in two months. The money received for the pallets is recognized as unearned revenue because the pallets have not been provided to the customer yet.
An error occurred trying to load this video.
Try refreshing the page, or contact customer support.
You must cCreate an account to continue watching
Register to view this lesson
As a member, you'll also get unlimited access to over 84,000 lessons in math, English, science, history, and more. Plus, get practice tests, quizzes, and personalized coaching to help you succeed.
Get unlimited access to over 84,000 lessons.Try it now
Already registered? Log in here for accessBack
- 0:00 Unearned Revenue Explained
- 0:58 Unearned Revenue Received
- 1:28 Unearned Revenue Earned
- 2:17 Canceled Contracts
- 3:01 Journal Entries
- 4:20 Lesson Summary
Unearned Revenue Received
In accrual method accounting, if the company receives money in advance for a product or service, you cannot recognize the money as earned revenue until the good or service is provided, which is why unearned revenue is recorded differently than earned revenue.
In our example of ABC Company's pallets, two months after the customer pays, the pallets are produced and delivered to the customer. To recognize the revenue now that it is earned, you will do an adjusting entry to move the money from unearned revenue to sales revenue.
Unearned Revenue Earned
In cases like ABC Company, you would record the revenue once the pallets are transferred to the customer. At that time, you can transfer the entire $25,000 from unearned revenue to an earned revenue account.
In cases like insurance and subscriptions, the revenue is recognized on a monthly basis. So, using our XYZ Company insurance example, let's say you sell a 12-month policy for $1,200 and receive the money January 1st; the policy takes effect on January 1st. At the end of every month, you will create an adjusting entry to move 1/12 of the money, $100, to sales revenue. By moving the money with an adjusting entry at the end of the month, it is recognized in the month that the revenue was earned. If all of the money is not earned, such as a cancelled contract, the transaction must be handled differently.
If the contract were cancelled and the good or service was not provided, then the company would need to refund the money the customer paid in advance. For this reason, unearned revenue is considered a liability until the good or service is provided, at which point it can be booked as earned revenue or sales revenue.
Keep in mind that if the insurance customer cancels the policy at any point in the 12-month period, they would be entitled to a refund of any money that had not been earned. In our XYZ Company example, if the customer cancelled the policy as of June 30th, six months into the contract, then they would receive a refund for half the money they prepaid: $600. The refund would come from the unearned revenue account.
This section will show you some of the journal entries involved with unearned revenue. First, is the receipt of unearned revenue.
XYZ sells a 12-month policy for $1200 and receives the money January 1st. The policy takes effect on January 1st. This entry books the money received as unearned revenue and recognizes the cash received. None of the money has been earned as of January 1st.
Next, we record the revenue as it is earned. At the end of January, the company has earned 1/12 of the money received. This entry recognizes $100 or 1/12 of the money in the current period. This adjusting entry would be done at the end of January when the books are closed. A similar entry would be completed at the end of each month.
Another example involves the manufacturing of a physical product. ABC Company receives $25,000 for 1,000 pallets to be delivered in two months. This entry books the $25,000 received as unearned revenue because the company has not produced or provided the pallets yet.
Once again, once we earn the revenue, it can be recorded. In two months, when the pallets are produced and delivered, an adjusting entry is made to move the money from unearned revenue to revenue for that fiscal period. The entire amount is moved because all of the money has been earned.
In summary, unearned revenue is received before the company provides the goods or service and is treated as a liability until it is earned by delivering or providing the good or service. Adjusting entries are used to recognize the revenue, in essence move it to a revenue account, when the money is earned by providing the goods or service.
To unlock this lesson you must be a Study.com Member.
Create your account
Register to view this lesson
Unlock Your Education
See for yourself why 30 million people use Study.com
Become a Study.com member and start learning now.Become a Member
Already a member? Log InBack
Unearned Revenue in Accounting: Definition & Examples
Related Study Materials
Explore our library of over 84,000 lessons
- College Courses
- High School Courses
- Other Courses
- Create a Goal
- Create custom courses
- Get your questions answered