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Hi.
Else, here.
And today we'll be talking about unearned revenue adjusting
entries and their impact on the accounting equation.
Before I start, it's important to understand
what unearned revenues are.
Unearned revenues are very similar to prepaid expenses.
Remember that prepaid expenses are not
expenses on the income statement,
even though they have the word expense in them.
Instead, prepaid expenses are assets.
Why?
Because they'll benefit the company in the future.
As they're used or consumed, these prepaid expenses
will become expenses on the income statement,
but only over time.
Unearned revenue is similar.
Students often recognize unearned revenue
as revenue on the income statement,
but they're not revenues.
What are they then?
Unearned revenues are a liability.
Why is that?
Well, say a customer pays a down payment on a car.
The car is not going to be delivered for two weeks,
but the customer has already given your company cash.
Your cash goes up because your assets go up,
but you've given nothing back to the customer except a promise
to give them a car in the future.
How do we record a future promise?
That's a liability.
Its a liability because you owe the customer something
in the future, an obligation that
will be settled when you deliver the car.
Will a liability ever become a revenue?
Absolutely.
When you deliver the car to your customer in two weeks,
you can recognize a revenue on the income statement
because you've earned it.
Are there other liabilities on the balance sheet
that are like unearned revenue that start off as liabilities
and later become revenues when they're earned?
Actually, unearned revenue might also
be called things like customer deposits, fees
paid in advance, advance subscription,
or any number of other names.
The accounts may have different names,
but they all mean the same thing.
A customer has provided cash to the company,
but didn't receive anything in return.
The company owes them a good or service in the future.
Remember, don't be fooled.
Unearned revenue is cash we've received
from a customer in advance of doing anything
for that customer.
We earn it later when we deliver the goods
or provide the service.
Unearned revenues are liabilities
on the balance sheet, most often under current liabilities.
Let's do an example so you really understand
the entries that impact the accounting equation when
we're doing and unearned revenue entry.
ABC Company agrees to provide car cleaning services
to a customer for $150 per month.
The customer pays for five months in advance.
5 times $150 means they give ABC Company $750 cash on January 1.
ABC has to report to the public quarterly.
That means they produce financial statements on
March 31.
Let's look at January 1, and see what entry ABC
Company needs to make.
Whenever we look at a transaction,
we have to ask ourself, what did we give up?
What did we get, if anything?
So what did we get?
We received cash of $750.
That means that assets, our cash account, increased by $750.
Did we earn anything?
When we receive cash, students often
assume that we have a revenue on the other side.
The question is, did we earn anything?
Cash doesn't indicate what we earned.
We have to ask, what did we do for the customer?
In this case, the answer is nothing.
We didn't do anything.
And because we didn't, we can't record revenue.
What did we give away?
Well, we gave away an IOU.
And that's an obligation, a liability in the future.
And because of that, we have to record
a liability, unearned revenue, under the element, liabilities.
Remember, this is because the company
has an obligation to the customer in the future
to provide a service.
What kind of transaction is this?
It's an external transaction because it's
measurable and realized.
Realized means that it happened in the past.
It's external because we exchanged something
with an outside party, someone who is external to the company.
Remember that external transactions
are called transactional entries,
indicating the transaction occurred with a third party.
And there's likely a paper trail,
such as an invoice or receipt.
Now let's fast forward three months.
We now stand in March 31.
We know that the company is going to produce
financial statements.
So we have to be sure that all the liabilities on our balance
sheet are still owed to third parties at March 31.
Liabilities have to be equal to the amount due in the future,
if not, we'll have to make an entry
to recognize that some of the liabilities have been settled.
If we look at our unearned revenue account,
the last time we did anything with that account
was on January 1.
So on March 31, we still have our January 1 balance,
which is $750.
We know that this account is a liability
because we owe the customer $750 of services in the future.
Do we still, now, at March 31 owe $750 of services
to a customer?
And the answer is no, not anymore.
We provided cleaning services for the last three months.
So we have to recognize that some of the liability
is now gone, settled.
We also have to recognize that we earned revenue.
So we have to move the value to the revenue account.
We said we provided three months of services to our customer.
And we know that we charge $150 per month.
So that means we've earned $450 over the last three months.
We have to reduce the liability account by that amount
because the value is no longer owed.
This means that our ending balance in the unearned revenue
account has to be updated to be $300, which
is our original $750 less than $450 liability
that was settled because we provided
the services to the customer.
We still have two months of obligation remaining
for the future.
That's why $300 of liability is left in the unearned revenue
account at March 31.
In order to reflect the fact that we've
provided three months of cleaning services,
what entry do we have to make to our accounting equation?
Well, we earned revenue.
And that means we need to recognize
that a service revenue of $450 has to be recorded.
Students often, then use cash as the other side of the entry.
Is that correct?
Well, we've not received any more money from our customer,
so cash is not impacted, and you should leave it alone.
Again, as we noted on the prepaid expense video,
adjusting entries never involve cash.
Instead, what we did is we provided
three months of services.
So we don't owe five months of services anymore.
And we have to reduce the liability account by the amount
that we have earned.
We need to record a reduction in the liability account
under unearned revenue of $450 because we don't
owe the customer that any more.
You already know that most transactions
are triggered by something, a paper
trail, a bill, an invoice.
But adjusting entries are internal entries.
We talked about this in the prepaid expense video.
There is no paper trail, nothing to tell us
that we have to make an entry, except the fact
that we provided a service to the customer.
Instead, it's an entry made by the company
to recognize that they earned something
by providing a service.
So the liability that was there before, now
moves to being a revenue.
The entry is triggered by the fact
that we have to report to external parties.
And so we need to make sure that only those liabilities that
are still owed remain on the balance sheet.
All the unearned revenues that have been settled,
have to be moved to the revenue account, which is exactly
what we did in this entry.
Let's look at both entries together.
Remember the first entry is a transactional entry
because it's an exchange with a third party that includes
a paper trail, like an invoice.
It's an external transaction, recording the receipt of cash
from our customer and the fact that we owe the customer
services in the future.
The second entry is an adjusting entry
because it adjusts the accounts before we publish
the financial statements.
It's an internal transaction because we adjust our records
internally.
There is no paper trail to tell us we have to do this.
Instead, we do it to recognize that we settled
the liability by providing a service,
and therefore, we earn revenue.
What would show on the balance sheet?
Well, only the balance at March 31,
which would be a current liability of $300.
Remember that unearned revenue can be called other things.
But they're transactional and adjusting entries
are exactly the same.
The liability and revenue need to be adjusted
at every reporting period end for what
has been earned since the last time the company published
their financial statements.
Adjustments can be made either monthly, quarterly,
or annually, depending on the company.
That's it for unearned revenue right now.
In our next video, we'll be focusing on accrued expense
adjusting entries.
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