In a classified balance sheet, unearned revenue is classified as which type of account?

Introduction / Context:
Unearned revenue, also called deferred revenue, appears frequently in accrual accounting. It arises when a business receives cash before providing the related goods or services. Exam questions often ask how unearned revenue should be classified in the balance sheet, because this tests understanding of the difference between cash receipt and revenue recognition under accrual principles.

Given Data / Assumptions:

• The business has received cash from customers in advance of performing services or delivering goods.
• The revenue recognition criteria are not yet met, so revenue cannot be fully recognised in the income statement.
• The business owes goods, services or a refund to customers in the future.
• The balance sheet must reflect this obligation appropriately.

Concept / Approach:
Under accrual accounting, revenue is recognised when it is earned, not simply when cash is received. When cash is received in advance, the business has an obligation to deliver goods or services in future periods. This obligation fits the definition of a liability, which is a present obligation arising from past events, the settlement of which is expected to result in an outflow of resources or services. Therefore, unearned revenue is classified as a liability until the performance obligation is satisfied and revenue can be recognised.

Step-by-Step Solution:
Step 1: Identify transactions where customers pay in advance, such as subscriptions, prepaid service contracts or advance ticket sales. Step 2: Recognise that at the moment of cash receipt, the business has not yet earned all of the revenue because services or goods are still to be provided. Step 3: Record a liability called unearned revenue or deferred revenue, representing the obligation to provide future services or goods. Step 4: As the business performs its obligations over time, reduce the liability and recognise revenue in the income statement. Step 5: Classify unearned revenue under current or non current liabilities depending on when the performance is expected to occur.

Verification / Alternative check:
Consider a magazine company that sells a one year subscription for 1,200 units of currency, paid in full at the beginning of the year. On the day the cash is received, the company has an obligation to deliver magazines each month for twelve months. It records cash of 1,200 and unearned revenue of 1,200. Each month, as one issue is delivered, the company recognises 100 as earned revenue and reduces the unearned revenue liability by 100. At any given point, the unearned portion continues to be a liability until the obligation is fully satisfied. This example clearly shows that unearned revenue is a liability, matching the correct option.

Why Other Options Are Wrong:
Option B is wrong because unearned revenue does not increase owner equity immediately; equity increases when revenue is earned and recognised. Option C incorrectly treats all cash as an asset without considering the obligation tied to unearned revenue. Option D ignores accrual principles and recognises revenue solely on cash collection, which is not acceptable in standard financial reporting. Option E misclassifies unearned revenue as a contra asset, but it does not reduce accounts receivable; instead, it stands as a separate liability.

Common Pitfalls:
A common pitfall is to confuse cash receipts with revenue, assuming that whenever cash comes in, revenue must be recognised. Another mistake is to treat unearned revenue as a negative asset rather than a positive liability, which distorts the balance sheet. Students may also forget to adjust unearned revenue over time as services are delivered, leaving liabilities overstated and revenue understated. Remembering that unearned revenue represents an obligation to customers helps classify it correctly as a liability and supports accurate revenue recognition.

Final Answer:
Liability, because it represents an obligation to provide goods or services in the future for which cash has already been received.