When an income is received in advance, the treatment in the Profit & Loss account and balance sheet, respectively, will be:
deducted from the respective income on the credit side; shown on the liabilities side.
Understanding Income Received in Advance in Accounting
Income received in advance, also known as unearned income, is revenue received by a company for services or goods that are yet to be provided or delivered. According to the accrual basis of accounting, income should be recognized only when it is earned, regardless of when the cash is received. Therefore, income received in advance represents an obligation to provide goods or services in the future, and as such, it is considered a liability.
Treatment of Income Received in Advance in Financial Statements
Let's analyse how income received in advance is treated in the two main financial statements: the Profit & Loss Account (also known as the Income Statement) and the Balance Sheet.
Profit & Loss Account Treatment
In the Profit & Loss account, the total income received during the period is credited. However, this total income might include amounts received in advance for which the corresponding goods or services have not yet been delivered or rendered in the current accounting period. To comply with the accrual concept, only the portion of income that has been earned during the current period should be shown in the Profit & Loss Account.
Therefore, the amount of income received in advance (which relates to a future period) must be deducted from the total income credited in the Profit & Loss account for the current period. This ensures that the Profit & Loss account reflects only the income earned during the relevant period.
Balance Sheet Treatment
As discussed earlier, income received in advance represents a liability for the business. The business has received cash but still owes goods or services to the customer. This obligation is a present responsibility arising from past events (receiving the cash) and will result in an outflow of economic benefits (delivering goods or services) in the future.
Liabilities are shown on the liabilities side of the Balance Sheet. Therefore, the amount of income received in advance is presented on the liabilities side of the Balance Sheet until it is earned. Once the goods or services are provided, the liability is extinguished, and the income is recognised in the Profit & Loss account.
Summary of Treatment
Here is a summary of the accounting treatment for income received in advance:
| Financial Statement | Side/Account | Treatment |
|---|---|---|
| Profit & Loss Account | Respective Income (Credit Side) | Deducted from the total income received. |
| Balance Sheet | Liabilities Side | Shown as a current or non-current liability. |
Evaluating the Options
Based on the correct accounting treatment:
- Option 1: added to the respective income on the credit side; shown on the assets side. This is incorrect because income received in advance must be deducted from income (as it's unearned) and it's a liability, not an asset.
- Option 2: deducted from the respective income on the credit side; shown on the assets side. This is incorrect because although it is deducted from income, it is a liability and not an asset.
- Option 3: added to the respective income on the credit side; shown on the liabilities side. This is incorrect because income received in advance must be deducted from income, not added.
- Option 4: deducted from the respective income on the credit side; shown on the liabilities side. This option correctly describes the treatment in both the Profit & Loss account and the Balance Sheet.
Revision Table for Adjusting Entries
Adjusting entries are made at the end of an accounting period to record revenues and expenses that have occurred but have not yet been recorded. This ensures that the financial statements adhere to the accrual basis of accounting. Here's a quick overview of common adjusting entries related to income and expenses:
| Item | Description | P&L Effect | Balance Sheet Effect | Type |
|---|---|---|---|---|
| Outstanding Expenses (Expenses Due) | Expenses incurred but not yet paid. | Added to respective expense (Debit) | Shown as Liability (Credit) | Accrued Expense |
| Prepaid Expenses | Expenses paid in advance, benefit not yet received. | Deducted from respective expense (Credit) or shown as expense for the period (Debit) | Shown as Asset (Debit) | Prepaid Expense |
| Accrued Income (Income Due) | Income earned but not yet received. | Added to respective income (Credit) | Shown as Asset (Debit) | Accrued Income |
| Income Received in Advance (Unearned Income) | Income received but not yet earned. | Deducted from respective income (Debit) or shown as income for the period (Credit) | Shown as Liability (Credit) | Unearned Income |
Additional Information on Unearned Revenue Accounting
Unearned revenue is another term for income received in advance. It arises when a company receives payment from a customer for goods or services that will be delivered or performed in a future accounting period. Until the goods or services are provided, the company has an obligation to the customer. This obligation is a liability.
When the company eventually provides the goods or services, the unearned revenue liability is reduced, and the revenue is recognised in the income statement. For example, if a company receives $1,200 for a 12-month service contract upfront, $1,200 is initially recorded as Unearned Service Revenue (a liability). At the end of each month, $100 ( $1,200 / 12) is earned. An adjusting entry is made to debit Unearned Service Revenue by $100 and credit Service Revenue by $100. This reduces the liability and recognises the earned income.
Proper accounting for unearned income is crucial for accurate financial reporting, ensuring that revenues are matched with the period in which they are earned, adhering to the revenue recognition principle and the matching principle under the accrual basis of accounting.
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