Is Unearned Revenue a Liability?
What is Unearned Revenue?
Unearned revenue, also known as deferred revenue or deferred income, is a financial term used to describe the money a company receives from customers for products or services that have not yet been delivered or earned. This occurs when a company receives advance payments from customers before providing the goods or services. Unearned revenue represents an obligation for the company to deliver the promised products or services in the future, and until that obligation is fulfilled, it is classified as a liability on the company’s balance sheet.
Business always depend on financial statements like balance sheets, income statement, cash flow statement etc to track financial records that are recorded as per the financial accounting principle. Some accounting software could able to generate these reports automatically, while some needs accounting professionals to pass Journals to record these unearned income.
What is a Current Liability?
Before we delve into whether unearned revenue is a liability, let’s understand what a current liability is. From accrual accounting perspective, we have 2 types of liabilities defined based on accounting period and its duration.
- Long-term liabilities – Liabilities those are more than a year to pay and settle.
- Short-term liabilities. its also called Current Liability.
A current liability is a financial obligation or debt that a company is expected to settle within one year or the operating cycle, whichever is longer. Current liabilities are crucial for a company’s short-term financial health and typically include items like accounts payable, short-term loans, and, in this case, unearned revenue.
Is Unearned Revenue a Liability?
Yes, unearned revenue is considered a Current liability. When a company receives advance payments from customers for products or services that are yet to be delivered, it assumes an obligation to fulfill those promises. As long as the company has not earned the revenue by delivering the products or services, it holds the customer’s payment as a liability. Once the products or services are delivered or earned, the unearned revenue is recognized as revenue and moved from the liability section to the revenue section of the company’s financial statements.
Example of Unearned Revenues
Let’s consider an example to illustrate unearned revenues.
Suppose Company A, a software company, signs a contract with a client to provide a year-long software subscription for $12,000. The client pays the full amount upfront. At the time of receiving the payment, Company A records the $12,000 as unearned revenue on its balance sheet.
As the months pass, Company A provides the software services each month, earning $1,000 in revenue for each month of service delivered. Over the year, the unearned revenue of $12,000 gradually reduces to $0 as each month’s service is recognized as revenue.
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Show the Journal Entries to Record Unearned Revenue is a liability.
The unearned revenue journal entry to record unearned revenue would be as follows:
Debit: Cash (or Accounts Receivable if not received in cash) – $12,000
Credit: Unearned Revenue – $12,000
As the revenue is earned each month, the journal entry would be:
Debit: Unearned Revenue – $1,000
Credit: Revenue – $1,000
FAQ on Is Unearned Revenue a Liability
Is unearned revenue a current liability?
Yes, it is considered a current liability since it represents an obligation to deliver products or services in the short term.
Where does unearned revenue go in the balance sheet?
It is listed under the current liabilities section of the balance sheet until it is earned and recognized as revenue. Few cases, it may be shown in long-term liabilities too. For example, SaaS annual subscription fees agreement for 3 years.
Is earned revenue a liability?
No, It is not a liability. Once the company has delivered the products or services and earned the revenue, it is recorded as an asset or equity depending on the nature of the business.
What is unearned revenue, an asset?
It is initially recorded as a liability because it represents a future obligation. However, as the company fulfills its promise by delivering the products or services, it is converted into an asset or revenue.
Where does unearned revenue belong?
It belongs to the current liabilities section of the balance sheet until the company fulfills its obligation and earns the revenue.
Is revenue a liability on the balance sheet?
It represents advance payments from customers, is considered a liability until it is earned by delivering the products or services. In subscription-based products, we show it as deferred revenue as its yet to receive.
Why is revenue in liabilities?
Revenue is initially classified as a liability when it is unearned because the company has not yet fulfilled its obligation to provide the products or services in return for the advance payment received. Once the Materials or Service delivery takes place, it could be shown under Current asset as “Cash” or “Bank” entries.
In conclusion, unearned revenue serves as an essential financial metric for businesses as it reflects the company’s future obligations to deliver products or services. By understanding and managing unearned revenue appropriately, businesses can ensure financial transparency and make strategic decisions that positively impact their overall financial health and customer relations.