On July 1, Squid Roe, Inc., collected cash in advance from a customer in July for services to be performed in July, August and September and recorded a debit to Cash and credit to Unearned Revenue for $3,000. Which of the following is the proper treatment of this event assuming monthly financial statements are prepared?

Question

BlackTom AI · Accepted Answer

Unearned revenue is a liability until services are performed, and monthly statements require recognizing revenue in the period it is earned.

Relevant concepts: accrual accounting, revenue recognition, matching principle, and treating unearned revenue as a liability that is reduced as services are provided.

Step-by-step reasoning and entries:
1. Initial cash receipt (July 1): customer prepays $3,000 for services in July, August, September.
   - Debit Cash $3,000
   - Credit Unearned Revenue $3,000
   This records the cash inflow and the obligation to perform future services.

2. Determine amount earned by July 31:
   - Total prepaid $3,000 covers 3 months (July, Aug, Sep).
   - Monthly revenue earned = $3,000 ÷ 3 = $1,000.

3. Adjusting entry on July 31 to recognize July’s earned portion:
   - Debit Unearned Revenue $1,000 (reduces the liability)
   - Credit Service Revenue $1,000 (recognizes revenue earned in July)

Intermediate balances after adjustment:
- Unearned Revenue balance = $3,000 − $1,000 = $2,000 (remaining obligation for Aug & Sep).
- Service Revenue recognized in July = $1,000.

Why the correct answer is correct:
- It follows accrual accounting by recognizing the portion of revenue actually earned during July, matching revenue to the period services were provided, and reducing the related liability accordingly.

Why other options are incorrect:
- Option 1 (debit Service Revenue, credit Unearned Revenue $1,000): reverses signs; debiting revenue would decrease it instead of recognizing revenue.
- Option 3 (no adjusting entry): fails to recognize revenue earned in July and violates the matching principle.
- Options 4 and 5 (adjust on Sept 30 for $3,000): delay recognition until the end of September; they would overstate liabilities and understate revenue in July and August.

Therefore, the proper treatment is: On July 31, an adjusting entry should be recorded that debits Unearned Revenue and credits Service Revenue for $1,000. This matches the provided correct answer.

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