When a company receives payment for goods or services prior to delivering the goods or performing the services, the income is unearned, and therefore, the company records the payment as a liability on its balance sheet rather than as income or revenue. Once the company satisfies its obligations and the transaction is complete, the payment is earned and accountants transfer the payment from the liability to the revenue account.
Unearned Income Definition
For financial reporting purposes, most businesses employ the accrual method of accounting for all transactions. As a result, a company must fully perform their obligations under a contract or other agreement before it can report the proceeds as revenue. Therefore, when the firm receives a prepayment from a customer for goods it will deliver at some point in the future, the company cannot report the payment as revenue since the income isn't earned until the time of delivery. In contrast, the cash method of accounting doesn't distinguish between earned and unearned income; rather, all that is necessary to report revenue is the receipt of funds.
Liability Journal Entries
Until the company delivers goods that are free of defects, the customer payment it receives represents a liability to the company. For example, if the customer cancels the transaction and requests a refund, the company is liable for returning the payment. Moreover, if the company is unable to provide the transaction's underlying goods, it has no legal claim to the funds. Essentially, the income is a liability until the company has a legal right to the funds, which always requires it to perform all obligations of the transaction first. At the time the company receives payment, it must prepare a journal entry to reflect the liability. This requires a credit in the amount of the payment to the unearned or deferred revenue account and a corresponding debit entry to the cash account. If the fiscal year closes before the company completes the transaction, the balance sheet will reflect the increase in liabilities for the unearned income.
Adjusting Unearned Income
Once the company completes the transaction, it must prepare a second journal entry to reduce the deferred revenue liability. This requires a debit to the deferred revenue account and a credit to the earned revenue account. Note, however, that the cash account is unaffected on the balance sheet.
Income Statement Implications
The adjusting journal entry made to the deferred revenue balance sheet account to recognize the earning of the income has significant implications on the income statement as well. The credit side of the entry to earned revenue is an income statement account that doesn't relate to the balance sheet. As a company posts credit entries to revenue throughout the year, the balance at the end of the fiscal year is equal to the gross revenue that it reports on the income statement to calculate net income.
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