This type of accounting is good to know if your firm collects cash prior to rendering services. You may be rendering services the following month or many months in the future. If that happens, there is a certain liability line item that should be used within the balance sheet. This also has impacts on income statement and cash flow items. I discuss in the video below:
Templates From the Video:
Quick Answer:
A contract liability, often referred to as unearned revenue, is a balance sheet obligation that arises when a company receives payment from a customer before delivering the promised goods or services. Until the obligation is fulfilled, this advance payment is recognized as a liability rather than revenue. Over time, as the goods or services are provided, the liability is reduced and revenue is recognized on the income statement.
Detailed Explanation:
1. Definition of a Contract Liability / Unearned Revenue:
- A contract liability is created when a company receives consideration (usually cash) from a customer in advance of delivering goods or performing services. Accounting standards (such as IFRS 15 and ASC 606) define contract liabilities as the entity’s obligation to transfer goods or services to a customer for which the entity has already received payment.
- In more traditional terms, this is often called "unearned revenue" or "deferred revenue" because, from the company’s perspective, it has not yet "earned" the right to recognize the amounts as revenue. Essentially, the company is holding an obligation to provide something of value to the customer in the future.
2. Initial Recognition on the Balance Sheet:
- When cash is received in advance, the journal entry typically involves:
- Debit to Cash (an asset)
- Credit to Contract Liability (Unearned Revenue) (a liability)
- This treatment ensures that the company acknowledges the responsibility to deliver something in the future. At this stage, no revenue is reported on the income statement because the earnings process is not complete.
- As the company delivers the promised goods or performs the contracted services over the life of the contract, it systematically reduces the contract liability and recognizes revenue. This is typically done proportionally to performance obligations met or based on the transfer of control over time. The corresponding journal entry when revenue is recognized might look like:
- Debit to Contract Liability (Unearned Revenue)
- Credit to Revenue (on the Income Statement)
- This step transfers what was previously a liability on the balance sheet into recognized revenue on the income statement. As a result, profit (or net income) can be affected once the obligation is satisfied and revenue is recognized.
Effect on the Balance Sheet:
When the contract liability is initially recorded, the company’s total liabilities increase, reducing equity indirectly since unearned revenue does not increase retained earnings or any equity component yet. As the company fulfills its obligations and recognizes revenue, the contract liability decreases. Over time, if no new advance payments are received, the contract liability will eventually be depleted as all the underlying performance obligations are satisfied.
Effect on the Income Statement:
No immediate impact occurs on the income statement when cash is first received since no revenue is recognized at that point. Later, as the performance obligations are met, revenue is recognized, increasing the company’s top line and potentially its net income (depending on related costs).
Effect on the Cash Flow Statement:
- Operating Activities: When cash is received in advance, it will increase the cash from operating activities in the period of receipt. However, this advance inflow does not immediately correspond to recognized revenue. Later, when the revenue is recognized, it does not affect the cash flow statement again, as this stage involves no additional cash movement—only a reclassification of the existing contract liability into revenue.
Thus, a contract liability affects timing differences between cash receipts and revenue recognition. The cash flow statement remains accurate in reflecting when the company gets paid, but only the balance sheet and income statement track the timing of when the revenue is actually “earned.”
In Summary:
A contract liability (unearned revenue) is a liability representing the obligation to provide goods or services for which the company has already received payment. It initially increases liabilities and cash on the balance sheet without affecting the income statement. Over time, as services are rendered or goods are delivered, the liability is reduced, and revenue is recognized on the income statement. This timing difference underscores the importance of understanding both the balance sheet and the income statement to get a complete financial picture of the company’s operations and performance.
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Article found in Accounting and Finance.
