The unearned revenue adjusting entry, step by step

When a customer pays before you do the work, the cash is yours but the revenue is not, yet. This page shows the two entries involved: recording the advance payment as a liability, and the adjusting entry that moves the earned part into revenue as the work gets done.

What is unearned revenue?

Unearned revenue is money a customer has paid for goods or services the business has not delivered yet. Other names for it are deferred revenue and customer deposits. Common examples are annual service contracts paid up front, subscriptions, retainers, gift cards and deposits on custom work.

The key question is what the business has in exchange for that cash. It has an obligation. It owes the customer either the work or a refund. Something the business owes is a liability, so unearned revenue sits on the balance sheet with the other liabilities, not on the income statement with revenue.

This can feel backwards at first. Cash came in, so it looks like good news, and it is. But revenue in accrual accounting means value delivered to customers, not cash collected. Until the business delivers, it hasn't earned anything. It has only been trusted with the customer's money.

Two entries: the receipt, then the adjustment

Unearned revenue always involves two moments, and each gets its own entry.

1. When the cash arrives. Cash goes up and the liability goes up. Debit Cash, credit Unearned Revenue. No revenue is recorded.
2. At each period end, after some of the work is done. The part delivered stops being owed and becomes earned. Debit Unearned Revenue, credit a revenue account such as Service Revenue. No cash moves.

The second entry is the adjusting entry. It belongs to the deferral family of adjustments, along with prepaid expenses. In both, cash moved first and the income statement catches up over time. A prepaid expense is the business paying in advance. Unearned revenue is the customer paying the business in advance. The overview on adjusting entries practice puts all four kinds side by side.

Worked example, part 1: receiving the advance

Here is the transaction from the lesson's free exercise:

Ask what changed. Copperleaf has $5,950.00 more cash, so Cash increases. Assets increase with a debit. Copperleaf also now owes the customer $5,950.00 of services. That obligation is Unearned Revenue, a liability, and liabilities increase with a credit.

Notice what is not in the entry: Service Revenue. Copperleaf hasn't done any of the work. If it closed its books today, its income statement should show no revenue from this customer, and its balance sheet should show both the cash and the obligation.

Worked example, part 2: the adjusting entry

The adjustment needs to know how much of the work is done. A premium exercise in this lesson gives that information:

Step 1: Find the amount earned per month

The contract is spread evenly over 12 months, so each month of service is worth $16,800.00 / 12 = $1,400.00.

Step 2: Multiply by the months delivered

Juniper has provided 2 months of service. The earned amount is 2 × $1,400.00 = $2,800.00.

Step 3: Move that amount from the liability to revenue

Unearned Revenue decreases, because Juniper now owes less. Liabilities decrease with a debit. Service Revenue increases, and revenue increases with a credit.

Step 4: Check the balance that is left

Before the adjustment, Unearned Revenue held $16,800.00. After it, the account holds $16,800.00 − $2,800.00 = $14,000.00. That should equal the months still owed times the monthly amount: 10 × $1,400.00 = $14,000.00. It does, so the entry is consistent.

If Juniper adjusts monthly from here, it records $1,400.00 each month. When all 12 months are delivered, Unearned Revenue is zero and the full $16,800.00 has been recognized as Service Revenue, spread across the year in which the work was actually done.

Following the balance through the year

It helps to watch the two accounts move together. Every dollar that leaves Unearned Revenue arrives in Service Revenue, so the two always add up to the original $16,800.00.

Halfway through the contract, half the money is earned and half is still owed. That symmetry is a quick way to sense-check an adjusting entry: the earned share should match the share of the work done. If your entry leaves the liability with a balance that doesn't fit the months remaining, recheck the monthly amount or the count of months.

The same table also explains what a reader of the financial statements sees. At the end of month 2, the balance sheet reports a $14,000.00 liability, and the income statements for those two months report $2,800.00 of revenue between them. Both numbers describe the contract honestly: some work done, most of it still to come.

Why the adjustment matters

Skip the adjustment and two things go wrong. Revenue is understated, so the months in which Juniper did the work look less profitable than they were. And the liability is overstated, so the balance sheet says Juniper owes customers more work than it really does. Anyone reading the statements, such as an owner, a lender or a buyer, would get a distorted picture.

The opposite error, recording revenue as soon as the cash arrives, is just as misleading. It makes the month the customer paid look very good and the following months look empty, even though the work is spread evenly across them. And if the customer later cancelled and asked for a refund, revenue that was never earned would have to be reversed.

Common mistakes

The exercises in this lesson are graded line by line, and each of these mistakes gets specific feedback.

• Recording revenue when the cash arrives. Crediting Service Revenue for Copperleaf's $5,950.00 on the day it is received treats the payment as earned. Nothing has been delivered yet. Credit Unearned Revenue instead.
• Putting every line on the wrong side. On receipt, Cash goes up (debit) and the liability goes up (credit). In the adjustment, the liability goes down (debit) and revenue goes up (credit). If you reverse these, ask what increased and what decreased before choosing a side. A liability increases with a credit and decreases with a debit.
• Recognizing the whole contract at the first adjustment. Crediting Service Revenue for $16,800.00 after 2 months counts ten months of work that hasn't happened. Only the months delivered, $2,800.00, are earned.
• Debiting Cash in the adjustment. This is the most common slip. The cash arrived when the contract was signed and was recorded then. At the period end, no money changes hands, so the debit goes to Unearned Revenue, not Cash. Debiting Cash again would count the same $2,800.00 twice.
• Recording only one line. In the mixed exercise, where you first decide whether the transaction is the receipt or the adjustment, it's easy to enter Cash and forget the liability. Every entry needs at least one debit and one credit, and the totals must be equal.

Receipt or adjustment? How to tell

The last exercise in the lesson mixes the two entries and asks you to decide which one the description calls for. In one version, a customer pays Copperleaf Studio $5,050.00 in cash for future services. That is a receipt: debit Cash $5,050.00, credit Unearned Revenue $5,050.00.

Look for these clues:

• "Paid in advance", "received a deposit", "for services it will provide": the receipt. Cash is involved.
• "Has now provided", "months of service delivered", "record the adjusting entry": the adjustment. Cash is not involved.

If you're unsure, ask whether money moved on the date of the entry. If it did, it's the receipt. If it didn't, it's the adjustment.

Unearned revenue compared with accrued revenue

The two names sound alike but describe opposite timing. With unearned revenue, the customer pays first and the work comes later, so the business carries a liability. With accrued revenue, the work comes first and the customer pays later, so the business carries a receivable, an asset. The adjusting entry for accrued revenue debits Accounts Receivable and credits revenue. The expense-side version of an accrual is covered on the accrued expenses adjusting entry page.

If you need a refresher on why liabilities increase with a credit, the journal entry practice problems page covers debits and credits from the start. The free exercise below gives you new numbers each time.