15 Reporting Unearned Revenue

Unearned revenue is money received by a or company for a service or product that has yet to be fulfilled. Unearned revenue can be thought of as a “prepayment” for goods or services that a person or company is expected to produce for the purchaser at some later date or time. As a result of this prepayment, the seller has a liability equal to the revenue earned until delivery of the good or service.

For example, you pay $1200 for a one-year membership at a local gym on January 1. Your payment of the entire years’ membership creates a liability for the gym until you “use up” some of your pre-paid membership. The transaction would be recorded as an increase to cash (debit) and an increase to unearned revenue (liability). These are both Balance Sheet accounts!

Every month the gym will make an entry to recognize the revenue from your membership. This will be a decrease in unearned revenue (liability) and increase in earned revenue (income). They will continue to recognize the $100 every month until you have “used up” your pre-paid membership.

Why then does your pre-paid membership create a liability for the company? If the gym burned down in May and you could no longer go to the gym, the company would be “liable” to you for the remaining 7 months of membership dues that you paid for but did not get to use. They would have to refund you $700—thus a liability is created.

This recognition of revenues when they are earned is at the heart of accrual accounting and the “matching principle.”