Question

Leon Wight, a newly hired loan analyst, is examining the current liabilities of a corporate loan applicant. He observes that unearned revenues have declined in the current year compared to the prior year. Is this a positive indicator about the client’s liquidity? Explain.

Short answer

Market analysts states that there is an increase in the unearned revenue liability, instead of giving warning signal, usually gives an affirmative signal about profitability and sales. With the enhancement of sales, the account of unearned revenue should also grow. Therefore, an increase in a liability is likely to be good news about the performance of the company.

Step-by-step solution

Meaning of current liabilities

Current liabilities are the liabilities that are payable within a financial year. It occurs either out of realization from current assets or by creating fresh current obligation.

Response to the decline of unearned revenue in the current year as compared to the previous year

Unearned revenue is an obligation that comes from the existing sales but for which some of the products or services are overdue to the customers in the future. When there is a sale, customers pay for the product delivered to them as well as for the future products or services. For this reason, the firm identifies revenue from the existing product and portion of the income from sale is listed as an obligation (unearned revenue) for the number of future products or services that are unpaid to customers. Market analysis advises that an increase in the unearned revenue liability is still regarded as a positive signal about the sales and income. With the growth of sales, the unearned revenue also grows. Hence, an increase in a liability is regarded as a positive news about the firm’s accomplishment. However, when the unearned revenue falls, the firm owes less future values but this also implies that sales of new products may have slowed.