Lesson 019 - Adjusting Entries 3: Deferred Revenue

Summary

The video explains accounting concepts related to revenue recognition, focusing on the handling of advance payments for tax consultancy services. A company receives $150,000 in advance for six months of services on November 1, 2020, but by December 31, only two months of service are rendered. The video demonstrates how to adjust journal entries to reflect earned and unearned revenue. It covers different methods—liability and income methods—and emphasizes proper revenue recognition to avoid accounting violations. The video aims to provide a clear understanding of adjusting entries for accurate financial reporting.

Takeaways

• 💼 The company provides tax compliance and consultancy services and received an advance payment of $150,000 for six months of service on November 1, 2020.
• 📅 The accounting period ends on December 31, 2020, meaning two months of services have been rendered by the time financial statements are prepared.
• 💰 On November 1, the company debits $150,000 in cash and credits a liability account for unearned tax consultancy fees.
• 🧾 By December 31, the company needs to adjust for the two months of service already rendered, recognizing $50,000 in revenue.
• 📝 The formula for recognizing earned revenue is: (Total advance payment) × (Months of service rendered / Total months of service).
• 📊 The adjusting entry on December 31 debits unearned revenue for $50,000 and credits revenue for the same amount.
• 🔢 At the end of 2020, the company reports $50,000 in earned revenue and $100,000 remaining in unearned revenue.
• ⚠️ Some companies incorrectly record the entire advance payment as revenue upfront, which violates the revenue recognition principle.
• 🔄 Using the liability method, the advance payment is initially recorded as a liability, while using the income method, it is immediately recorded as revenue.
• ✅ Regardless of the method, only $50,000 should be recognized as earned revenue, and $100,000 should be left as unearned revenue at the end of the year.

Q & A

What is the main service provided by the company in the script?

The company provides tax compliance and consultancy services.

When did the company receive the advance payment of $150,000, and for how long was the service to be provided?

The company received the advance payment of $150,000 on November 1, 2020, for a six-month period of tax compliance and consultancy services.

What type of accounting entry is made on November 1 when the company receives the advance payment?

On November 1, the company debits $150,000 to cash and credits $150,000 to an unearned revenue account specifically for tax consultancy services, recognizing it as a liability.

How does the company recognize revenue by December 31, and how is it calculated?

By December 31, the company recognizes two months of service rendered. The revenue is calculated as $150,000 (the total payment) multiplied by 2/6 (the portion of service rendered), resulting in $50,000 recognized as revenue.

How can the monthly revenue be calculated?

The monthly revenue can be calculated by dividing the total advance payment of $150,000 by 6 (the number of months). This results in $25,000 per month, and for two months, it amounts to $50,000.

What adjusting entry is made on December 31 for the revenue recognition?

On December 31, the company debits the unearned tax consultancy liability account for $50,000 and credits the tax consultancy revenue account for $50,000, recognizing the revenue for the two months of service provided.

What is the remaining unearned revenue balance at the end of 2020?

The remaining unearned revenue at the end of 2020 is $100,000, which covers the remaining four months of service to be rendered.

What is the consequence of incorrectly recognizing the full $150,000 as revenue immediately upon receiving the payment?

If the full $150,000 is recognized as revenue immediately, the revenue will be overstated. In reality, only two months of service were rendered by December 31, so the correct amount to recognize as revenue is $50,000, with $100,000 remaining as unearned revenue.

What are the two methods mentioned for handling the recognition of unearned revenue?

The two methods mentioned are the liability method, where unearned revenue is credited as a liability and adjusted as services are rendered, and the revenue method, where the full payment is recognized as revenue immediately, which violates the revenue recognition principle.

How much revenue is earned in 2020, and how much remains as unearned revenue?

In 2020, $50,000 of revenue is earned for the two months of services rendered. The remaining unearned revenue is $100,000, which represents the services to be provided in the following months.