Income or revenue is earned when the process of providing goods or services has been completed. Any income or revenue that is received before being earned is known as unearned income or income received in advance.
Accounting for Unearned Income or Revenue
Unearned income or revenue is accounted for using either the liability method or the income method.
Under the liability method, the whole amount received in advance is initially recorded as a 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 portion of the unearned revenue into earned revenue.
Under the income method, the entire amount received in advance is recorded as income using the following journal entry:
If a portion remains unearned at the end of the accounting period, it is converted into a liability with the following adjusting entry:
Mr. Green Light, a commission agent, received $3,600 on 1 July 2016 as a commission from a client. One-third of the commission received is in respect of work to be done next year.
Required: Mr. Green Light prepares financial statements on 31 December each year. Make necessary journal entries in the books of Green Light.
(1) Liability Method
Mr. Green Light will record the following journal entry at the time of the receipt of $3,600 in cash from his client:
One-third of the total amount received belongs to the next accounting period. Therefore, only two-thirds of the unearned commission liability (3,600 × 0.66) will be converted into commission revenue at the end of the accounting period.
For this purpose, the following adjusting entry will be made on 31 December 2016.
(2) Income Method
Mr. Green Light will record the following journal entry at the time of the receipt of cash:
On 31 December 2016, one-third of the commission revenue (3,600 × 0.33) will be converted into unearned commission liability.
Students may note that the amount of the adjusting entry under both the methods is different, but the final amounts are the same (i.e, cash received is 3,600, commission revenue is $2,400, and unearned commission is $1,200).