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Is Unearned Revenue a Liability?

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Is Unearned Revenue a Liability Explained

Is unearned revenue a liability account or not is an important topic of discussion in the accounting field. This revenue is the one that the company earns in advance from its clients who have booked any purchase of goods and services and made the payment in advance for them. They will receive the goods at a later date.

As it can already be understood, such advance revenue is highly beneficial for the business as they can use it for any internal purpose. It can also be invested in opportunities that will provide lucrative returns to the business. They can also be used to repay loans with interest or maybe maintain inventory levels. However, such cases depend on the amount that is received.

This can be viewed as a good source of cash inflow for the company. But proper analysis will reveal that even though it is useful, it is still a liability. This is because since the business has not delivered the goods and services to the clients but has accepted the payment beforehand, they are under the obligation to return it to them at any time, under any circumstances.

For this reason, the question is unearned revenue a liability account is answered by the fact that it is rightly recorded on the liability side of the balance sheet and remains there till the delivery is made, after which it turns into revenue and is recorded in the income statement.

Typically, this value is shown as a current liability on the balance sheet of the company. But that again depends on the period within which the goods should be delivered. If the delivery date is extended beyond 12 months after the transfer of the revenue, then it will be recorded under long-term liability.

In this article, we provide the top 3 reasons why unearned revenue is classified as a liability -

Why Is Unearned Revenue A Liability?

This is a critical question as to why is unearned revenue a liability, which should be analysed by every accountant because it will clarify any doubt they may have about the entire process.

Investors can use this figure to estimate the amount that the business may earn in future and make an idea about its sales and revenue levels, which will give a hint about its profitability. But it should be noted that the rise in sales and revenue figures may also be the result of good performance and supportive market conditions.

Thus, it is important for investors and analysts to study the financial statements in detail and also understand the financial position of the business in the market. Given below are some cases or situations that may lead to unearned revenue which are often seen during business transactions. Let us study as to why is unearned revenue a liability, in detail.

Reason #1 - Payment is Received in Advance

When the company receives the money in advance for the product or the services, but the goods have not been delivered, or the services have not been rendered to the party providing the advance. As per the accrual accounting, a person cannot recognize the money and cannot treat the money received as the earned revenue until and unless the goods have been delivered or the services have been rendered to the party, as the case may be. It is because the unearned revenue of any company is recorded differently than the earned revenue. The advance received becomes the liability to the company till the goods have been delivered or the services have been rendered to the party and will be shown on the liability side of the balance sheet.

Explanation of Unearned Revenue (Sales) in Video

Reason #2 - Can Cancel the Contract any Time

The person receives the money from one party for which the goods have been delivered, or the services have been rendered to the party. Now, in case the party cancels the contract, then, in that case, the company would be liable to refund the amount of money received from the customer in advance. So, considering this reason, the unearned revenue for which the goods have been delivered or the services have been rendered to the party is considered the liability and will be shown as the liability in the balance sheet of the company until the goods are delivered, or the services are provided, after which the company can book the amount received as the earned or sales revenue.

Reason #3 - Services not Provided/Goods not Supplied

The company should recognize the revenue earned once the goods have been supplied or the services have been rendered to the customers if the risk and rewards related to goods or services have not been transferred to the customer from the supplier. Until then, the company should not recognize the revenue even if it has received the amount against it.

There are some regulatory and reporting rules related to the same. Under the supervision of the Securities And Exchange Commission (SEC), the public companies should adhere to the rules in order to recognize revenue. If they do not abide by those rules, the revenue amount cannot be recognized during that particular accounting period.

Some rules that are worth mentioning over here are that there should be a complete delivery or complete transfer of ownership for the seller to the buyer. The amount can be reasonably estimated or there should be a probability of collection.

Examples

Let us try to understand the concept that is unearned revenue a liability or asset, with the help of some suitable examples, as given below:

Example #1

Company B ltd. Got the order to supply office equipment to Company C ltd after two months, for which the advance payment was received in full. Since the goods have not been provided to Company C, risks and rewards related to the goods have not been transferred. Now the company will treat the advance amount received as its liability until the risk and rewards are transferred, after which the entire advance will be transferred from unearned revenue to the earned revenue account.

Example #2

Company X ltd produces and supplies sports equipment in one area. Mr. Y provided the advance to the company X ltd of $ 50,000 for the supply of certain sports equipment after one month. After 15 days, Mr. Y asks the company to cancel the order. The company, after receiving the cancellation request from the customer, cancelled the order and refunded the amount back to Y. So, in this case, Company X cannot recognize the amount received as advance as its revenue and has to show the same as its liability because when the order gets cancelled, then it is liable to refund back the advance amount to the customer.

Example #3

Mr. X uses amazon.com, and recently he got to know about the exceptional services provided by amazon.com like unlimited access to music and movies, free shipping of the products within two days, etc. He wants to benefit from the same, so he purchased the annual subscription to Amazon for $ 119. For this $ 119, Amazon must provide the service for one year. Now for Amazon, the amount received from Mr. X of $ 119 becomes unearned revenue because the company receives the payment as an advance in full while no services have yet been provided to Mr. X.

Initially, a full amount of $ 119 will be recognized by the company Amazon.com as the unearned revenue in its balance sheet when the full amount has been received as an advance. However, at the first month's end, the monthly portion out of the total amount, which comes to $ 9.92 ($ 119 / 12), will be reduced from the portion of unearned revenue and will be recorded and treated as the revenue of the company. So at the first month's end, the earned revenue from Mr. X's subscription will come to $ 9.92, and the unearned revenue shown on the company's balance sheet will come to $ 109.08 ($ 119 – $ 9.92). The same procedure will be followed in each subsequent month till the end of the 12^th month as after the last month; the company will recognize the last portion of the payment received from Mr. X as its revenue.

Unearned revenue is the money received by the company or an individual for the service or product that has to be rendered or delivered yet. Since the money is received in advance by the company, the same is to be recorded on the balance sheet of the company as the liability because the advance received represents the debt owed by the company to the customer who has given the advance but has not received the services or goods for which the amount is paid, which answers the question that is unearned revenue a liability or asset.

Once the company delivers the product or provides the service to the company for which the amount is received in advance, then the unearned revenue will become the revenue and will be considered as the income on the income statement of the company and will no longer be a liability.