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Accounting Fundamentals | Adjusting Entries - Part 2 of 4: Unearned Revenue - YouTube
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Mark Farber: Hi, I'm Mark Farber and this
is Accounting Fundamentals.
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In our last video, we started to talk about
adjusting entries and we talked about prepaid
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expenses.
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Remember that a prepaid expense is nothing
more than an expense that a company has paid
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for in advance and then records the expense
on a regular basis over the period of a number
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of months or years or whatever.
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Initially, the prepaid expense is an asset
because the company is owed a certain service
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or something.
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As they accrue that over time, that asset
becomes an expense on the income statement.
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What happens in reverse?
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What happens if a company sells something
and gets paid in advance for it?
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In our last example we used an insurance contract,
and we said that a company purchased a one
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year insurance contract and paid for it in
advance on January 1st.
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I thought we'd look at the opposite here.
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Here we have the insurance company, XYZ Insurance
Company, and they sell a one year insurance
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policy on January 1st for $2,400 dollars cash.
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Now remember, they're going to receive $2,400
of cash on January 1st, but we can't record
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that as revenue because in order to have revenue,
two things have to occur.
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In the case of an insurance policy, you have
to substantially complete the delivery of
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the policy or provide the service and payment
has to be reasonably assured.
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Well, payment is reasonably assured, they've
already been paid on January 1st, but they
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haven't delivered anything on that date yet.
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So they don't have revenue.
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We're not going to do the cash accounting
anymore because we don't care about that.
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Let's jump right into the accrual accounting.
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First of all, let's just remind ourselves
since it's a 12 month policy and it's a $2,400
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dollar policy divided by 12 months, the policy
is worth $200 dollars per month.
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If we do the journal entries for this transaction,
on January 1st this company is going to debit
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cash because they received the check, $2,400,
and they're going to credit a liability account
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called "unearned revenue".
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It's kind of a strange name, but what it basically
tells us is that there's revenue that's coming,
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$2,400 dollars' worth of it, but it hasn't
been earned yet according to the accounting
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rules.
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Again, they haven't provided the service yet.
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On January 1st that's what they have.
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They have cash has increased by this $2,400
dollars and this liability account, called
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unearned revenue, has increased by $2,400.
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Well, on January 31st ... I'm just going to
keep moving this over to give myself some
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more space ... On January 31st, they've now
delivered one month of this 12 month contract.
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They've completed one month, and therefore,
they've earned one month of revenue.
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One month again is equal to $200 dollars.
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On January 31st what this company will do
is it will debit this unearned revenue account.
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Again, remember that, because unearned revenue
is a liability, a credit increases the account
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and a debit will decrease the account.
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We're going to decrease the amount of insurance
that is owed to people or revenue that has
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not yet been earned, so we'll debit unearned
revenue by $200 dollars, the amount that one
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month is worth.
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And we will credit revenue for $200 dollars.
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At the end of January, the company has now
earned $200 dollars of the $2,400 dollars
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that it received on January 1st.
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Same thing will happen then end of February,
Feb. 28, they'll enter a new transaction.
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Debit unearned revenue $200 dollars and credit
revenue $200 dollars.
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Again, at the end of each month, when the
company's doing its adjusting entries, it
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will put in an entry for recognizing $200
dollars' worth of revenue that it's now earned,
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until the very end of the year, December 31st,
they'll do this for the last time.
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At that point, this insurance company will
have earned the entire $2,400 dollars and
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it will begin anew next year when they get
a check for the next policy from this particular
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customer.
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That's unearned revenue.
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Kind of the opposite of prepaids, or if you
want the flip side to prepaids, kind of a
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mirror image of it.
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We'll go on in the next coming videos and
we'll look at some more of the adjusting entries
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that a company has to make at the end of each
accounting cycle, in order to get ready for
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preparing the financial statements.
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