5 Revenue Recognition and Accruals

Unearned Revenue

What if the customer pays, but the company hasn’t done their part? A great example of unearned revenue is deposits. Companies often require customers to pay a deposit to compensate the company for their costs in the event that the customer pulls out of the contract. This is particularly common with custom goods.

For example, a company receives a request for 100 custom sweatshirts printed with the customer’s logo. The company will likely require the company to pay a deposit before the sweatshirts are printed. Why? Because the shirts are printed with the customer’s logo, they are not saleable to any other customer. The inventory is worthless if the customer decides not to take the sweatshirts, so the company loses money. The solution to this problem is to require the customer to pay a portion of the contract price upfront: a deposit.

Back to revenue recognition. If the company has not met their obligation, they have not earned revenue. The trouble is that when the customer pays, the company has to record the cash received:

What account should be used for the credit in this journal entry? The answer is unearned revenue: a current liability account. Let’s look back at the criteria for a liability. Does unearned revenue meet these criteria?

Present Obligation?A Liability is a Present Obligation.
The company owes something now—even if they aren’t going to pay until later.

Yes, the company owes their customer goods or services.

Arising from Past Events?A Liability Arises from a Past Event.
There are many possible past events that lead to a present obligation. Accepting a deposit for a custom order is one of those possibilities: unearned revenue arises from a past event!

Yes, the customer paid for it and thereby triggered a transaction. A contract with a customer and receipt of cash give rise to unearned revenue.

Resulting in an Outflow of Economic Resources?A Liability is Expected to Result in an Outflow of the Entity’s Resources.
Usually (but not always), this means the company will pay out cash. But, in cases involving unearned revenue, the liability will be settled in goods or services. The T-shirt collection with the customer’s logo is a resource which will be delivered to the customer!

Yes, the company will transfer economic resources in the form of inventory or salaries paid for services performed. If the company cannot fulfill their contract obligation, they have to return the cash to the customer which itself is an outflow of economic resources.

The journal entry will look like this:

My Turn:

On 01 October, CustomShirts Inc. agrees to sell 100 custom sweatshirts to a customer. The contract price is $2,000. Half of the contract price is due up front as a deposit, and the remainder is due on receipt of the sweatshirts. The $1,000 deposit was received on 05 October. The sweatshirts were complete and delivered to the customer on 20 October. The customer e-transferred the $1,000 outstanding on 22 October.

The cost of the sweatshirts to CustomShirts is $1,250.

Required:

Create journal entries to record revenue recognition and receipts from the customer. Label your journal entries with a date and transaction description.

Now your turn to practice with unearned revenue!

And again!!

We have talked about revenue accounts, but does periodicity affect expenses as well? Great question—yes it does! Let’s look at expenses next.