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Why is unearned revenue considered a liability?

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Unearned revenue is a liability in a company's balance sheet because the firm has not yet completed a contract, nor has the company fully delivered goods or services in return for prepayment, according to AccountingTools. The company gradually adds revenue to its balance sheet until the contract is done.

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Examples of unearned revenue include a lease agreement, a service contract, prepaid insurance and a legal retainer. All of these types of services are paid in advance, notes AccountingTools. For instance, Company A pays Company B $10,000 in November for plowing services related to an upcoming winter. Company B has unearned income, listed as a liability, until the five-month contract for plowing snow off Company A's parking lot is completed in March. Every month, Company B takes $2,000 of the $10,000 unearned income liability and makes it revenue. At the end of March, all $10,000 becomes revenue at the completion of the service contract.

Companies that receive unearned, or prepaid, income have a legal obligation to fulfill the contract terms. Extra prepaid income may be used to invest in other areas of a company or to purchase more inventory, explains Investopedia. However, a company that does not deliver the prepaid goods or services may be held liable in court if the contract is not fulfilled.

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