Question

How does unearned revenue arise? Why can it be classified properly as a current liability? Give several examples of business activities that result in unearned revenues.

Short answer

Unearned revenue arises when a company receives the payment for a good or service that is yet to be delivered or rendered respectively.

The company decreases the balances in the unearned revenue account and increases the balance in the revenue account, as the revenue is earned by the company. Thus, the unearned revenue account is usually classified as a current liability on the balance sheet.

Examples of unearned revenue are prepaid rent, prepaid insurance, annual subscriptions for a software license.

Step-by-step solution

Definition of Unearned Revenue

Unearned revenue occurs when cash is obtained by the company as a payment from a customer before producing goods or rendering the services as promised to the customer. However, it is regarded as a prepayment for goods and services that will be conveyed at a future date.

Classification of unearned revenue as a current liability

Unearned revenue is an assumption made to show the obligation made to the customer to refund the assets received in advance in case of the nonperformance of the aforesaid contract, in turn earning the rights over the assets received. However, there might be an element of unrealized profit included in the liabilities. When the unearned revenues are grouped as such, it is ignored fact that the amount of unrealized profit holds uncertain and usually not material in relation to the total obligation.

Examples of Unearned Revenues

• The amount paid by the company for insurance in advance.
• The amount paid by the company for services in advance.
• The amount paid by the company for expenses in advance.