Hence, they are also called "advances from customers".
It is to be noted that under the accrual concept, income is recognized when earned regardless of when collected.
And so, unearned revenue should not be included as income; rather, it is recorded as a liability. This liability represents an obligation of the company to render services or deliver goods in the future.
At the end of the period, unearned revenues must be checked and adjusted if necessary. The adjusting entry for unearned revenue depends upon the journal entry made when it was initially recorded.
There are two ways of recording unearned revenue: (1) the liability method, and (2) the income method.
Liability Method of Recording Unearned Revenue
Under the liability method, a liability account is recorded when the amount is collected. The common accounts used are: Unearned Revenue, Deferred Income, Advances from Customers, etc. For this illustration, let us use Unearned Revenue.
Suppose on January 10, 2014, ABC Company made $30,000 advanced collections from its customers. If the liability method is used, the entry would be:
Take note that the amount has not yet been earned, thus it is proper to record it as a liability. Now, what if at the end of the month, 20% of the unearned revenue has been rendered? This will require an adjusting entry.
The adjusting entry will include: (1) recognition of income and (2) decrease in the liability initially recorded (since some of it has already been rendered). The adjusting entry would be:
Actually, we are simply separating the earned part from the unearned portion. Of the $30,000 unearned revenue, $6,000 is recognized as income. In the entry above, we are removing the 6,000 from the 30,000 liability. The balance of unearned revenue is now at $24,000 ($30,000 credit and $6,000 debit).
Income Method of Recording Unearned Revenue
Under the income method, the accountant records the entire collection as income. Using the same transaction above, the initial entry for the collection would be:
If at the end of the year the company earned 20% of the entire $30,000, then the adjusting entry would be:
By debiting Service Income for $24,000, we are decreasing the income initially recorded. The balance of Service Income is now $6,000 ($30,000 - 24,000), which is actually the 20% portion already earned. By crediting Unearned Income, we are recording a liability for $24,000.
Notice that the resulting balances of the accounts under the two methods are the same (Cash: $30,000; Service Income: $6,000; and Unearned Income: $24,000).
On December 1, 2013, DRG Company collected from TRM Corp. a total of $60,000 as rental fee for three months starting December 1.
Under the liability method, the initial entry would be:
|Unearned Rent Income||60,000.00|
On December 31, 2013, the end of the accounting period, 1/3 of the rent received has already been earned (prorated over 3 months).
We should then record the income through this adjusting entry:
|Dec||31||Unearned Rent Income||20,000.00|
In effect, we are transferring $20,000, one-third of $60,000, from the Unearned Rent Income (a liability) to Rent Income (an income account) since that portion has already been earned.
If the company made use of the income method, the initial entry would be:
In this case, we must decrease Rent Income by $40,000 because that part has not yet been earned. The income account shall have a balance of $20,000. The amount removed from income shall be transferred to liability (Unearned Rent Income). The adjusting entry would be:
|Unearned Rent Income||40,000.00|
If you have noticed, what we are actually doing here is making sure that the earned part is included in income and the unearned part into liability. The adjusting entry will always depend upon the method used when the initial entry was made.
If you are having a hard time understanding this topic, I suggest you go over and study the lesson again. Sometimes, it really takes a while to get the concept. Preparing adjusting entries is one of the most challenging (but important) topics for beginners.