By David Lund
Just like baseball has an unearned run as a scoring feature, in business we have unearned revenues. In this piece I will discuss the difference between earned and unearned revenue and how it applies to the hospitality business.
First off though we need to review the American classic game of Baseball and how an unearned run works. This will be especially important for those of us who are not the sport’s most avid fans. In baseball you score an unearned run when an official, the umpire, decides the player crossed home plate due to an error (mistake) by the defending team. A good example is: an outfielder drops the ball and the runner on third base is able to make it to home plate before the outfielder is able to locate the dropped ball and throw it to the catcher. That’s an unearned run.
In the hotel business we earn income or revenue (the same thing) when we deliver service. In my workshops we do a piece on the difference between the two types of income. Most people think that income is earned when the money is paid. But this is not the case. An advance deposit is a good example of this. When someone pays us money to hold the room we have not yet earned the income, so we cannot take that deposit and treat it as revenue yet. We must hold it as a liability until we earn it. This is a tricky concept at first glance. How can a deposit be a liability? It’s a liability because use of the room has not happened yet! We have a duty to return the deposit under most conditions if the client should cancel in the appropriate period of time. These features make this transaction a liability. We record the payment as a debit to cash (asset) and a credit to the deposit account (liability).
With the advance deposit example, the income is not earned until the guest actually arrives. Once the guest has come to stay, we move the deposit from the liability to the asset side on the guest ledger account. Each night they stay with us we book the room revenue, and this goes against the deposit until it is all used up. The nightly recording of the room revenue from an occupied room is a perfect example of earned income. This practice goes to support the matching principle that states we match revenues with expenses regardless of when the money is received.
Another good example of unearned income or revenue is rent received in advance. In most hotels some space is rented out for shops, offices or even vitrines (a fancy word for showcases). Many times, the rental agreement will call for rent to be paid by the tenant to the landlord in advance. In this case rent is due for the entire year on January 15th. When a check for the full years rent is received, it creates a problem; the income has not yet been earned. Therefore rent is unearned income and must be treated as a liability until we earn it.
With the rent example the transaction is booked as follows. The rent for January is recognized as earned and the remaining balance of the payment is placed in the unearned rent account which is a liability. From this point on, each month 1/12 of the value of the unearned rent received in January will be moved from the liability account to the rent revenue account. This process is a great example of the matching principle and the conservatism principle.
We’re matching revenues to the periods they are earned, in this case each month this year we can match 1/12 of the value of the payment as revenue that is earned. We are conservative in our approach to recognizing the revenue. In this case it would be a mistake to recognize all the income in January, as attractive as it might sound, as it would be a contradiction to the conservative principle. The conservatism principle clearly states that we can only recognize revenue when we’re completely assured that it was earned. In the case of the rent there might be concern that the tenant could cancel the lease and be due the balance of that rent. Both of these facts tell us how to treat this transaction.
A final example of unearned income that is particular to hotels is an attrition or penalty charge to a group that does not meet its commitment of room nights. In many cases this charge includes an, “if you re-book” clause that states the customer can get a credit for some or all of the penalty charged if they bring the hotel an additional piece of business. Just like the rent example above, we cannot recognize this payment as income until it is earned. In this case it’s simply a matter of knowing when the condition of re-booking expires. On that date we can recognize the revenue.
That is the story of earned and unearned revenues