The income or revenue received before it is earned is known as unearned income or revenue or income received in advance. Income or revenue is earned when the process of the provision of goods or services has been completed. Any income or revenue received before the completion of such process is considered unearned income or revenue.
Accounting process of unearned income or revenue
Unearned income or revenue is accounted for using one of the two methods. These are liability method and income method. We shall discuss both on this page.
Under liability method, the whole amount received in advance is initially recorded as liability by debiting cash and crediting unearned revenue or income. The journal entry is given below:
At the end of the accounting period, the following adjusting entry is made to convert a part of unearned revenue into earned revenue.
Under income method, the entire amount received in advance is recorded as income by making the following journal entry:
If a portion remains unearned at the end of the accounting period, it is converted into liability by making the following adjusting entry:
Mr. Green light, a commission agent has received $3,600 on July 1, 2016, as a commission from a client. One-third of the commission received is in respect of work to be done next year. Mr. Green light prepares financial statements on December 31 each year. Make necessary journal entries in the books of Green Light.
(1). If liability method is used:
Mr. Green Light will record the following journal entry at the time of receipt of $3,600 cash from client:
One-third of the total amount received belongs to the next accounting period. Therefore, only two third of unearned commission liability (3,600 × 2/3) will be converted into commission revenue at the end of the accounting period. For this purpose, the following adjusting entry will be made on December 31, 2016.
(2). If income method is used:
Mr. Green Light will record the following journal entry at the time of receipt of cash:
At December 31, 2016, one-third of the commission revenue (3,600 × 1/3) will be converted into unearned commission liability.
It may be seen that the amount of adjusting entry under both the methods is different but final amounts are the same i.e, cash received 3,600, commission revenue $2,400 and unearned commission $1,200.