When a business collects cash in advance for goods or services to be delivered in the future, the revenue has not yet been earned and is recorded as a liability (typically labeled Unearned Revenue or Customer Deposits). The adjusting entry to convert liabilities to revenue is made when the business earns this revenue by fulfilling its obligation.
Debit: Cash
Credit: Unearned Revenue (Liability)
As the service is provided or the goods are delivered, part of the liability is converted into earned revenue.
Debit: Unearned Revenue (Liability)
Credit: Revenue Earned (or a similar account)
The adjusting entry ensures that the revenue is recognized in the period when it is earned, aligning with the accrual accounting principles of the Revenue Recognition principle. This prevents inflating income before services are provided.
A company receives $9,000 in December for a three-month rental, initially recorded as Unearned Rent Revenue. Each month, $3,000 is earned and transferred to the Rent Revenue account through an adjusting entry:
Debit: Unearned Rent Revenue $3,000
Credit: Rent Revenue $3,000.