Unearned revenue (also called deferred revenue) is a liability which represents the consideration received by a company for performance obligations which it has yet to satisfy.
Under the prevailing revenue accounting standards, a company identifies performance obligations under each contract, allocates the contract price to each obligation and recognizes revenue as and when it satisfies the performance obligations regardless of when the cash is received.
When a performance obligation has been satisfied (i.e. when goods/services have been provided) but cash is not yet received, a company records a receivable. On the other hand, when cash has been received but the company has yet to satisfy the performance obligations, the company books the receipt of cash by recording a corresponding unearned revenue. In this sense, the unearned revenue is just the opposite of accounts receivable. The receipt of cash is recognized as a liability because the company must either provide the underlying goods or services or refund the consideration.
The unearned revenue is recognized at an amount equal to the consideration received. If the contract has a significant financing component or foreign currencies are involved, the unearned revenue may be subject to finance cost, exchange differences until the performance obligations have been satisfied.
On satisfaction of the performance obligation, the unearned revenue is adjusted and revenue is recognized. Examples of entities whose books may contain significant unearned revenues include newspaper publishers, entertainment companies, telecommunication operators, etc. because the nature of their business is such that cash is received before goods and/or services are provided.
Voice is a VoIP company which provides innovative voice calling solutions. Assume that during the month of January 20X2 its users purchased talk time worth $10 million. This must be utilized by the subscribers by the end of March 20X2.
Voice would record this purchase as follows:
|Unearned Revenue||10 million|
The purchase of talk time is just an advance payment for services which Voice has yet to provide. Since there is a cash inflow and an increase in cash there is an offsetting increase in liabilities.
Let’s assume Voice has a single performance obligation which is satisfied over time.
If the users consumed $8 million of the talk time purchased in January by the end of February, the company can recognize an equivalent amount of revenue.
|Unearned Revenue||8 million|
$2 million worth of revenue is still unearned at the end of February (assuming no additional purchase of credit). If the users had purchased $9 million worth of talk time the balance in the unearned revenue at the end of February would have been $11 million ($2 million opening unearned revenue plus $9 additional talk time purchased).