Companies may consider a revenue as realized after receiving cash from customers, but may not recognize it in accounting books as earned until later based on revenue recognition principle. Unearned revenues often relate to products or services that companies deliver or perform over multiple accounting periods, and are recorded as a liability on balance sheet rather than income statement. Any prepayments of cash as unearned revenues are adjusted to earned revenues after companies have completed their sales.
The revenue recognition principle prescribes that companies may recognize a revenue only when it is both realized or realizable and earned. A revenue is realized or realizable when the revenue received is in cash or readily convertible to cash. But a company cannot recognize a realized or realizable revenue until it has earned it. A company may consider a revenue as earned only when it has substantially delivered a product or performed a service. Therefore, an unearned revenue arises when a company receives payments in advance but has yet to deliver the product or perform the service.
Companies may receive prepayments for future services in certain situations such as payments for rent or tuition. A company will render its future services over time and must record any prepayments as unearned revenues at the time received. As a company performs the related services over time, it can recognize portions of the prepayments as earned revenue accordingly. For example, at the end of a rental term or the start of a semester, prepaid rent or tuition will be considered as earned rental revenue or tuition revenue.
Companies record unearned revenue as a liability on their balance sheet rather than as revenue on income statement. When a company receives cash as advanced payments for later services, accounting entries debit the cash account and credit a liability account under unearned revenue instead of the revenue account for the income statement. The unearned revenue as a liability indicates that the company is liable for performing future services that customers have paid for in advance.
As companies have provided their services over time, the unearned revenue as a liability is reduced and the revenue as earned is increased. Companies make such adjustments often at the end of an accounting period through adjusting entries. An adjusting entry would debit unearned revenue to reduce the liability and credit revenue to recognize it as earned. Eventually, when companies have fully performed their services, the unearned revenues will be reduced to zero and their total amount will have been transferred into the earned revenue account.