Published in: Accounting

Unearned revenue debit or credit?

Author Obotu Agape Oguche

Published on: October 21, 2022

Is unearned revenue debit or credit? Businesses make revenue from the sale of their goods or from providing services to their clients. Nevertheless, there are situations whereby a customer pays for a good or service in advance. In such an instance, the company has made revenue from this transaction but hasn’t earned it yet because the goods or services that were paid for haven’t been delivered to the customer. This revenue is what we call ‘unearned revenue‘.

In accounting, unearned revenue is treated as a liability and not as an asset or revenue, as some people might think. This is because it is the money paid to a business in advance before the business actually delivers the goods or services to the customer. Hence, the business owes the customer and is obligated to deliver the goods or service at a later date. Since unearned revenue is a liability, will it be recorded as a debit or credit? In this article, we will discuss, unearned revenue, debit, credit and the correct journal entry for unearned revenue.

Related: Is Cost of Goods Sold a Debit or Credit? (COGS)

As a result of this advance payment, the seller has a liability that is equal to the revenue earned until the good or service is delivered. That is, unearned revenue is treated as a current liability because it is thought of as a debt or obligation that is owed to a customer. This means that unearned revenue will be earned and converted from liability to actual revenue when the distribution or delivery of what the customer paid for has been done. When the company or individual delivers the goods or service to the customer, they can now credit the income as revenue. Until then, unearned revenue is recorded under current liabilities, because it is expected to be settled within a year.

Sales revenue is recorded as unearned revenue in the financial records when money is received from a customer for goods or services that have not yet been delivered but will be delivered at a later date. In as much as unearned revenue is treated as a liability in the books, it is usually advantageous to the seller from a cash flow perspective. The seller tends to have the cash to perform the required services that have been paid for.

Common examples of unearned revenue include airline tickets, a rent payment made in advance, services contract paid in advance, prepaid insurance, annual magazine subscriptions, a legal retainer paid in advance, etc. As earlier said, receiving money before performing the paid service can be beneficial. The early receipt of cash flow can be utilized for several other activities, such as paying interest on debt and purchasing more inventory.

Businesses can profit greatly from customers paying in advance to receive their products or services. The cash flow from unearned or deferred revenues can be invested right back into the business by purchasing more inventory or paying off debt. This positive cash flow can keep the operation of the business thriving. However, these businesses must ensure they deliver the products to the customers on time, to keep transactions steady and drive customer retention. This is why it is important to recognize unearned revenue as a liability and not as revenue.

Unearned revenue for a month can be calculated by dividing the amount received for providing goods or rendering services by the number of months of services or goods for which the amount is received. For instance, if professional fees of $6,000 are received for six months. In order to calculate the unearned revenue for a month, the $6,000 is divided by the 6 months, which will give us $1,000. This is what is recognized as the monthly unearned revenue.

Unearned revenue reporting requirements

The U.S. Securities and Exchange Commission (SEC) has established several criteria that a public company must meet to recognize revenue. Therefore, revenue recognition is deferred if these criteria are not met. According to the SEC, there must be persuasive evidence of an arrangement, a determined price, collection probability, or the ability to make a reasonable estimate of an amount for the allowance for doubtful accounts, and completed delivery or ownership shifted to the buyer.

Unearned Revenue Account

Unearned revenue is recorded as a liability on the company’s balance sheet. It is treated as a liability account because the revenue has not been earned and represents something (be it products or services) that is owed to a customer. As the prepaid product or service is delivered to the customer over time, it is then recognized as revenue and recorded on the income statement.

If a company doesn’t treat unearned revenue as a liability and instead recognizes it as revenue at once, revenues and profits would initially be overstated, and then understated for the additional periods in which the profits and revenues should have been recognized. This is also a violation of the matching principle because revenues are being recognized at once, and the related expenses are not being recognized until later periods.

Hence, unearned revenue is perfect as a current liability on a company’s balance sheet. This can only change if the prepayment made for the goods or services is due to be provided 12 months or more after the payment date. In this case, the unearned revenue will appear as a long-term liability on the balance sheet.

Now, that we have an understanding of what unearned revenue is and how it is treated in a company’s financial statements, is unearned revenue debit or credit? In order to answer this, let us look at what a debit and credit mean to understand the correct entry for deferred revenue.

See also: Cash sales debit or credit?

Debit and credit entry

In the double-entry accounting system, a debit and credit entry is used to record any and all transactions within a business’s chart of accounts. In accounting, when a transaction is recorded, a debit entry must have a corresponding credit entry that equals the same amount. That is, in bookkeeping, every transaction has to be exchanged for something else that has the exact same value. Therefore, the total of the debit and credit entries for any transaction must always equal each other so that these transactions are said to be in balance.

For instance, a contractor bills a client $1000 to retile a shower and the client gives the contractor an advance payment of $500 before any work is done. This $500 paid to the contractor is unearned revenue. For accounting purposes, the contractor would have to record this $500 unearned revenue in his books as a debit of $500 to the Cash account and the same amount as a credit to the Unearned revenue account. It doesn’t end here; when the contractor finishes half of the job, he makes an adjusting entry to his record where he debits the Unearned revenue account by the $500 and credits the Service revenue account by the same amount.

As seen in the illustration above, credit and debit are the same amounts, which is the standard in double-entry bookkeeping. Also, as shown above, each transaction is always recorded in at least two accounts. Note that, a debit entry will increase an asset or expense account and reduce a revenue, equity, or liability account. A credit entry, on the other hand, will increase revenue, equity, or liability accounts and reduce an asset or expense account.

Now, that we have an understanding of what unearned revenue, debit, and credit are in financial reporting, we can now answer the question ‘is unearned revenue debit or credit?’. Let’s further discuss this.

Related: Cost of sales debit or credit?

The initial entry of unearned revenue should be a debit to the cash or bank account and a credit to the unearned revenue account because this revenue is a liability for the recipient of the payment. This journal entry shows that the business has an influx of cash but the cash has been earned on credit. That is, the cash is a pre-payment on goods to be delivered or services to be provided later.

Later on, once the individual or company actually provides the goods or services, an adjusting journal entry will be made. As the individual or company earns the revenue, it reduces the balance in the unearned revenue account with a debit entry and then increases the balance in the revenue account with a credit entry. That is, the unearned revenue account will be debited and the service revenues account will be credited by the same amount. Until then, the unearned revenue account is usually classified as a current liability on the balance sheet.

Debit and credit journal entry for unearned revenue

Since many businesses record revenue using the accrual system of accounting, revenue will only be recognized when the goods or services have been delivered to the customer. Therefore, if payment has been received in advance for a good or service that is yet to be delivered, it becomes a liability which is reported as a line item – Unearned revenue or Deferred revenue on the balance sheet.

Therefore, the initial journal entry for unearned revenue will be as follows:

As shown in the journal entry above, the initial entry of unearned revenue would be a debit to the cash or bank account and a credit to the unearned revenue account because this revenue is a liability for the recipient of the payment. Hence, unearned revenue is not a debit but a credit. This means that the unearned revenue normal balance is a credit balance.

Even though revenue was made, unearned revenue will not be entered into the company’s income statement. It can only be recognized on the income statement as revenue when it has been earned by delivering prepaid goods or services. Until then, unearned revenue is reported on the liability side of the balance sheet to show that the business owes the reported amount in terms of the goods or services yet to be provided.

Debit and credit journal entry for unearned revenue when prepaid goods or services have been delivered

When the unearned revenue is earned, by the company delivering the goods or services that were paid for, the liability of unearned revenue decreases, and revenue increases. That is, when the business later delivers the good or service owed to the customer, the unearned revenue account is decreased by a debit entry and the revenue account is increased by a credit entry.

Therefore, the journal entry for unearned revenue that has been earned will be as follows:

See also: Retained earnings debit or credit?

Why unearned revenue is not recorded as a debit but as a credit

Unearned revenue is not recorded as a debit but as credit, because it is a liability and as such would have a natural credit balance. The reason why unearned revenue will have a credit balance rather than a debit balance all falls back to the accounting equation:

Assets = Liabilities + Equity

The accounting equation above appears in the exact structure of a balance sheet. The asset account in a balance sheet has a natural debit balance that offsets the natural credit balance of liabilities and equity accounts. When a company receives prepayment for goods or services, the company incurs unearned revenue which automatically increases the company’s current liabilities. Liabilities and equity usually have credit balances that are increased with a credit entry. Therefore, unearned revenue as liability will be a credit entry and its account balances in a T-account will be on the right-hand side of the ledger.

Moreso, if a company records unearned revenue as an asset instead of a liability, then its total profit would be overstated in this accounting period. Also, the accounting period where the revenue is actually earned will then be understated in terms of profit. In addition, not entering revenue received in the same period as expenses paid for a project also violates the accounting principle. The accounting principles state that revenue and expenses for the same project must be matched. Hence, recording unearned revenue as an asset (debit) and not a liability (credit) will go against this accounting rule.

See also: Is Capital Debit or Credit?

Examples showing the debit and credit journal entries of unearned revenue

You record unearned revenue in your company’s balance sheet as soon as you receive it. You record it as a liability because when you receive unearned revenue, you have taken upfront payments or pre-payments before the actual delivery of the products or services. Hence, for this transaction, you will debit the cash or bank account and credit unearned revenue under current liabilities. However, you may record unearned revenue on your balance sheet under long-term liabilities only if you will deliver the products or services a year or more after receiving the prepayment.

After you provide the prepaid products or services, you can now adjust the journal entry, because you have earned the money. This time around, you will debit the unearned revenue account and then credit the revenue account. Over time, as you deliver the product or service, the unearned revenue converts to earned revenue. Let’s look at some examples to explain this:

Example 1

Company XYZ hires ABC Plowing and pays $10,000 in advance. The company pays ABC Plowing in advance to plow its parking lot so that they will give the company first plowing priority throughout the winter months. At the time of payment, ABC Plowing has not yet earned the revenue, so it records all the $10,000 paid in an unearned revenue account, using the journal entry below:

Debit and credit journal entry for unearned revenue

ABC Plowing expects to be plowing for Company XYZ for a period of five months, so it elects to recognize $2,000 of the $10,000 unearned revenue, as the unearned revenue per month in each of the five months. That is, $10,000/5 months will give $2,000. In the first month of the five months, ABC Plowing will record the monthly unearned revenue as follows:

Debit and credit journal entry for monthly unearned revenue

After 5 months, ABC Plowing was able to deliver the plowing service for company XYZ, it will then adjust the journal entry because it has earned the money. This time around, ABC Plowing will debit the unearned revenue account and then credit the revenue account. Hence, the journal entry for this would be as follows:

Debit and credit journal entry for unearned revenue that has been earned

Example 2

A landlord on the 1st of September receives rent for 12 months in advance, which amounts to $12,000. This rent received would be recorded in the books as advance rent, and $1,000 ($12,000/12 months) would be treated as the rental income each month.

These would be the following journal entries recorded:

Debit and credit journal entry for unearned revenue (advance rent received)

After each month, the landlord earns the rental income and records the rental income earned for each month as:

Debit and credit journal entry for unearned revenue when rental income is earned (monthly basis)

Example 3

An insurance company received a premium of $24,000 from Mr. Peter for 12 months. Since the period covered is 12 months, the $24,000 received would be recorded as a liability in the books of insurance providers. Subsequently, an amount of $2,000 would be recognized as income every month. The following are the journal entries for this:

Debit and credit journal entry for unearned revenue (unearned insurance income received)

Debit and credit journal entry for unearned revenue when insurance income is earned (monthly basis)

Related: Sales return debit or credit?