Question

Accounting Theory

Question

Short term deferrals (prepaid and unearned revenues) are classified as current assets and current liabilities. As such included in working capital.

Required

1.         Why do accountants include short-term unearned revenues as current liabilities? Do they meet the definition of liabilities found in the conceptual framework? Do they affect working capital? Explain.

2.         Present arguments for excluding unearned revenues from current liabilities. Do they affect liquidity? Explain.

Answer 1

1. Unearned revenue, or deferred revenue, typically represents a company's current liability and affects its working capital by decreasing it. Unearned revenue is recorded when a firm receives a cash advance from its customer in exchange for products and services that are to be provided in the future. Because a company cannot recognize revenue on this cash advance and it owes money to a customer, it must record a current liability for any portion of the cash advance for which it expects to provide services within a year. Since current liabilities are part of the working capital, a current balance of unearned revenue reduces a company's working capital.

Unearned revenue typically arises when a company receives compensation and it still has to provide products for which the payment was made. Consider a media company that asks its customers to pay $120 in advance for annual subscriptions to its monthly magazine. When a customer sends a $100 payment, the media company records a $100 debit to its cash balance and a $100 credit to its unearned revenue account. When the company ships magazines to a customer once a month, it can decrease its unearned revenue by $10 by recording a debit to the unearned revenue account and a $10 credit to its revenue account.

Working capital is the difference between a company's current assets and its current liabilities, which it records on its balance sheet. If a company has a balance of earned revenue for services it intends to provide within a year, this balance is considered a current liability and would decrease the working capital.

2. Cash is excluded from working capital, especially in large amounts, is invested by firms in treasury bills, short term government securities or commercial paper. ... Unlike inventory, accounts receivable and other current assets, cash then earns a fair return and should not be included in measures of working capital.