Unearned Revenue

How to Accurately Calculate the Liability of an Unearned Revenue?

What is unearned or deferred revenue? How is the liability associated with it calculated? Read to find all the answers.
BusinessZeal Staff
Last Updated: Jun 3, 2018
It's the revenue and profit generated by a company, which drive its future performance. There is a certain part of revenue, known as the unearned or deferred revenue, which every accounting professional should know about.

Accounting is tracking the cash flow and handling the day-to-day finances of a business, with an eye for the sales target. Every single penny that is earned or spent by the business needs to be accounted for. Revenue is the income generated by a company, as a result of sale of goods and services.

Definition

There are several business transactions that generate an unearned cash pile. Unearned revenue is that which is collected from customers by any business, but hasn't been earned yet. In other words, the goods sold or services promised by the company have not yet been provided to the customers, though payments have been collected in advance. It is the sum of money which has been credited into the accounting books of the company in advance.

Until the services and goods are delivered to the end customer, its associated liability cannot be cleared. It is termed to be a liability, because, in the event that the terms of the sales contract or service contract are not met, the company may have to refund the money, back to the customers. Hence, it's essential that the accounting department of a business considers this revenue to be a liability to be repaid, till that sum of money is actually earned. It is the exact opposite of accrued revenue, which is a sum that is yet to be received by the company.

There are several instances where unearned revenue may be recorded. One of the prime examples is a lease contract, wherein the tenant may have to pay rent in advance. Until the tenant has actually lived through the period of the lease contract, the collected rent is deferred revenue for the owner of the rented apartment.

The price of goods sold online needs to be generally paid in advance, before they are delivered to you. This generates deferred revenue for the online business, from whom you buy the goods. This is especially true of products, which are bought through pre-ordering, where you pay the discounted price, weeks in advance, before delivery. Most GSM cell phone services collect a pre-paid balance amount from customers, before they have used the service. This is paying your cell phone bill in advance, which generates a sizable amount of unearned revenue for the cell phone carrier.

Calculation

A journal entry for deferred revenue is calculated by summing up the total prepayments received by the business, before goods and services are actually delivered. Till the service of sales contract is fulfilled, it is treated as a liability. Generally, a business will maintain an account for every customer and show the deferred revenue as balance on that account. It will only be debited from the customer account after the terms of service or sold goods are delivered.

Liability associated with this type of revenue needs to be carefully handled by any business and is best left untouched until the service obligations are met or goods are delivered.