Alternative Methods for Accounting for Unearned Revenue

Preflight airline tickets are an example of unearned revenue.

Unearned revenue, also called deferred revenue, is money paid to the business but not yet earned by the business. Items and services that customers prepaid for, including subscriptions, rent and any deposits for future services or items to be delivered, are all types of unearned revenue. Specific examples of unearned revenue include college tuition paid prior to the student attending classes and airline tickets bought before the customer has taken the flight.

Accrual Versus Cash Methods

The U.S. accounting standards are known as generally accepted accounting principles (GAAP). Under GAAP, companies must use accrual accounting methods instead of cash accounting methods. For accrual accounting, accountants make adjustments at the end of accounting periods. For unearned revenue, accountants make an initial record of the payment and then adjust the actual earnings at the end of the accounting period. Cash methods may be used by foreign businesses or by some small U.S. businesses. Under the cash method, accountants will simply record the revenue as earned when the cash is paid.

Earning Unearned Revenues

Unearned revenues are earned in one of two ways: through the passage of time, as is the case with rent, or through the rendering of services, as is the case with college tuition. Accountants must record all relevant financial occurrences, so unearned revenue must be recorded twice, once when the cash is paid and once when the money is earned. Once earned, the revenue may be treated as any other revenue and added as income or stockholder equity. Until it’s earned, accountants hold the revenue as a liability.

Recording Unearned Revenue

To account for unearned revenue under the accrual method, accountants make initial records when the cash is received. The unearned revenue is recorded as an increase to credit and an increase to liability. The increase to liability is labeled as an unearned revenue account to keep accountants from accidentally recording it as income before it’s earned.

Adjusting Unearned Revenue

Accountants may record the revenue earned when it is earned by decreasing the funds in the unearned revenue liability account and add it as income or stockholder equity. In most cases, it isn’t practical for the accountant to make daily adjustments as the revenue is earned, so the unearned revenue liability account is often adjusted at the end of an accounting period. The remaining liability is transferred over as unearned revenue for the next accounting period.

References

• Accounting Info: Accrual Basis vs. Cash Basis Accounting
• “Financial Accounting, Sixth Edition”; Jerry J. Weygandt, et al.; 2008
• AccountingCoach: Would You Please Explain Unearned Income?

Resources

• Principles of Accounting: Income Measurement