Adjusting entry for unearned revenue: examples and how to
The basic building blocks for accurate income statements and balance sheets are accurate journal entries. One such journal entry is the adjusting entry for unearned revenue. This adjusting journal entry for unearned revenue is made in compliance with Generally Accepted Accounting Principles (GAAP) and is used to track payments made in advance for goods or services. Before we discuss this adjusting entry, let us have a clearer understanding of unearned revenue.
What is unearned revenue?
Unearned revenue is also referred to as deferred revenue, advances from customers, deferred income, prepaid revenue, or unearned income. Companies that usually have unearned revenue as part of their accounting books are those that offer pre-order options for products, services that require prepayments, or subscription-based products and services.
Some examples of products and services that could be paid for in advance include rent, insurance, magazines, clothes, newspapers, software, internet, cable TV, electricity, airline tickets, legal retainers, and books.
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Does unearned revenue require an adjusting entry?
How to adjust unearned revenue
Determine the earned revenue
Make the adjusting entry
Read about: Why are adjusting entries necessary?
Accounting for unearned revenue
As mentioned earlier, unearned revenue is money received by a business for products or services that have not yet been delivered. Thus, unearned revenue is a liability since the company owes a service or product to the customer who made the prepayment, which means the company is obligated to deliver a good or render a service to the customer at a later date in the future different from the day of prepayment.
To keep track of all prepayments received, companies normally make journal entries to keep track of the transaction once the payment is made and later make an adjusting entry for unearned revenue when the good or service is delivered or rendered respectively.
Most businesses use the accrual method of accounting for their business transactions. Under this method, income is recognized when it is earned and not when it is collected. Due to this, making adjusting entries for unearned revenue becomes a necessity once the revenue becomes earned.
The Securities and Exchange Commission (SEC) further stipulates in its revenue recognition bulletin that before unearned revenue becomes earned, there must be persuasive evidence that a purchase arrangement exists, delivery of the good or service to the customer has occurred, the selling price of the product or service is determinable or fixed, and collectibility is reasonably assured.
Unearned revenue journal entry
The unearned revenue journal entry is the first journal entry made by any business that has received payment in advance for products or services. This journal entry is made in accordance with the accounting debit and credit rules whereby a debit to one account is complemented by a credit to another account.
The debit and credit made are normally of the same amount. In the case of unearned revenue, once a prepayment has been made by the customer, the business will record such a prepayment as a debit to the cash account and a credit to the unearned revenue account.
The debit to cash shows that there has been an increase in the company’s assets in form of cash and there has also been a corresponding increase in unearned revenue by the credit to the unearned revenue account.
The credit to the unearned revenue account shows an increase in the company’s liabilities since the company owes products or services to the customer that made the prepayment. The table below shows the journal entry made when a client pays in advance for a good or service.
| Date | Account | Debit | Credit |
|---|---|---|---|
| DD/MM/YYYY | Cash | $$ | |
| Unearned revenue | $$ |
Adjusting entry for unearned revenue
As companies fulfill their obligations to the customer by providing the client with the goods or services that they had earlier paid for, the company’s liabilities get reduced while their assets increase. The journal entry made to recognize the reduction in unearned revenue and the corresponding increase in revenue is known as the adjusting entry for unearned revenue. This adjusting entry for unearned revenue is made by debiting unearned revenue and crediting revenue.
In some instances, the company may want to be more specific about the kind of revenue that has been earned. In such an instance, if the earned revenue is for the sale of goods, it will be recorded as sales revenue while earned revenue for services rendered will be recorded as service revenue. Since the unearned revenue is a liability, the adjusting entry for unearned revenue reduces the company’s liability by the debit to unearned revenue and increases the company’s revenue by the credit to the revenue account. The adjusting entry for unearned revenue is as follows:
| Date | Account | Debit | Credit |
|---|---|---|---|
| DD/MM/YYYY | Unearned revenue | $$ | |
| Revenue | $$ |
The adjusting entry for unearned revenue is made gradually as the balance sheet gets adjusted in line with the reduction in their obligation to the client. Generally, companies do not recognize the revenue all at once, instead, gradual adjusting entries like the one above are made until the whole unearned revenue becomes fully earned. If however, the payment advance is only for one product or only one specified period of service, then the adjusting entry for unearned revenue is made once when the revenue is earned.
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Unearned revenue adjusting entry examples
Example 1
Suppose a car insurance company received an upfront payment of one year from Mr. Gray to cover his car insurance throughout 2023 in January. If he paid a total sum of $14,400 for the yearly insurance, the company will make the following journal entry upon receipt of the payment.
| Date | Account | Debit | Credit |
|---|---|---|---|
| 1/1/2023 | Cash | $14,400 | |
| Unearned revenue | $14,400 |
As each month passes, the car insurance gradually recognizes the earned revenue by making adjusting entries for unearned revenue. The adjusting entry will be made monthly so that their balance sheet’s current liabilities get reduced while the revenue on the income statement increases. The monthly adjusting entry for unearned revenue will be as shown in the table below:
| Date | Account | Debit | Credit |
|---|---|---|---|
| 1/2/2023 | Unearned revenue | $1,200 | |
| Revenue | $1,200 |
To determine the monthly car insurance amount, the lump payment is divided by 12 to arrive at the $1,200 which is recorded as the adjusting entry for unearned revenue monthly until the year ends and the initial lump payment becomes fully earned by the car insurance company.
Example 2
Assuming a book publishing company made some books available for pre-order in January, but the books will get delivered in April. If Mrs. Jones made a pre-order worth $50 in January, the publishing company will record the transaction as follows:
| Date | Account | Debit | Credit |
|---|---|---|---|
| 31/1/2023 | Cash | $50 | |
| Unearned revenue | $50 |
Since the payment is a one-time payment for books, the company earns the money once they deliver the books to Mrs. Jones in April. When this happens, they make an adjusting entry for unearned revenue as follows:
| Date | Account | Debit | Credit |
|---|---|---|---|
| 3/4/2023 | Unearned revenue | $50 | |
| Revenue | $50 |
What is the debit and credit entry when adjusting an unearned revenue?
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Conclusion
The adjusting entry for unearned revenue is usually made at the end of the month or quarter to capture the amount that has been earned by the company from the unearned revenue.
Businesses recognize earned revenue in this manner so as to avoid overstating or understating the company’s liabilities or income during specified periods. For instance, if the whole unearned revenue is recognized as revenue before the good or service is provided, it will overstate the company’s actual revenue for that period while understating its liabilities for the same period.
Furthermore, in subsequent periods when the products or services get provided to the customer, the company’s revenue will become understated while its expenses or cost of goods sold associated with providing the service or good will be overstated.
Hence, to avoid this confusion and ensure accurate reporting of financial transactions, the adjusting entry for unearned revenue is an important entry that aids in recognizing both revenue and expenses within the correct accounting period. This ensures that the company does not provide misleading information to its shareholders and creditors by presenting unsubstantiated balance sheets or income statements.
