You’ve probably been in a meeting where a lot of ideas are circulated about how to improve an existing product or service. In these meetings, differing opinions can quickly turn into a battle of long-winded defenses. Fortunately, the emergence of A/B testing – once thought to be exclusive to tech firms – has become a viable and cost-effective way for all types of businesses to identify and test value-creating ideas.

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A/B Testing: in statistical terms, A/B testing is a method of two-sample hypothesis testing. In laymen’s terms, this means comparing the outcomes of two different choices (A and B) by running a controlled mini-experiment.

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Although the concept of A/B testing was galvanized by Silicon Valley giants, the rationale behind A/B testing is not new. The practice borrows from traditional randomized-control trials to create smaller, more scalable experiments.

As a very basic example, let’s say you are an abstract artist. Your paintings are informed by the world around you, but you cannot merely mimic landscapes. You are confident in your technique, but you still aren’t sure how the outside world—and more importantly art critics—are going to respond to your new paintings. Assessing the quality of art is a famously challenging process.

If you were to employ A/B testing for this scenario, you would start by creating two different paintings that are exactly alike. As you continue working, you would decide to change one small thing—let’s say you add a red square to one painting and not the other. Again, this means that everything about the paintings are alike except for this one modification. Once the change is made, you display the two paintings in randomly selected art galleries across the country and wait for your art agent, or another unbiased third party, to gather the reactions and report back to you.

After each painting has been placed in a reasonable amount of art galleries, perhaps you are informed that the painting with the small change received significantly more praise, or maybe it did not. The hypothetical outcome does not matter. Rather, what matters is that you can be reasonably confident that your change will or will not make the painting better, and you can go on to create better art as a result.

USA’s Most Wanted by Komar and Melamid used a different technique –surveys –to create a painting that catered to the art preferences of the American public.
Source: Dia Art Foundation.

The randomization aspect of this design is explicitly emphasized because randomization is the gold-standard for eliminating biases. Art is a subjective field and evolves over time, and so do the preferences and opinions of customers, clients, or coworkers. A/B testing is not a static process, and tests can be repeated or complemented if companies believe that findings may not be valid or applicable anymore.

Companies like Google, Amazon, and Facebook have all used A/B testing to help create more intuitive web layouts or ad campaigns. Customers benefit and companies can reap measurable monetary returns by catering to market preferences. Momentum is now building to use this method outside of Silicon Valley. Jim Manzi, the founder of Applied Predictive Technologies, has advocated for the use of randomized experiments in other aspects of business, politics, and society in his book Uncontrolled.

As a final note, it is imperative that the design of A/B testing be rigorous to ensure the validity of your results. Furthermore, there may be some decisions where internal opinions are more cost-effective or timely.

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Because financial valuation is always forward-looking, today's market prices should incorporate all information about a company's performance - including expectations of future performance. As a result, anyone looking to make money on an individual stock (or write a compelling blog post) needs to look for surprises - times when reality over- or underperformed expectations.

So far, this holiday season seems to be off to a roaring start. Online sales on Cyber Monday hit a record $3.45 billion this year, and online sales on Black Friday topped $3 billion for the first time. UPS CEO David Abney reported to Bloomberg on November 28 that he expected 14% higher shipping volume this year than last year.

So, when researching this holiday blog post, I found several articles speaking glowingly about the stocks of UPS and FedEx, driven by this huge demand. So far, in 2016, UPS is up 20% and FedEx is up 30%, they said, boldly.

It makes sense, and it makes a compelling story. But is is true? The market is supposed to incorporate all information - was the market really surprised that this holiday season was good?

Actually, it turns out, the market has been relatively unimpressed by online sales this season. For example, Amazon's stock fell 3.79% between Black Friday and the end of the month of November, while the overall market (as represented by the S&P 500 index) only fell 0.27%. That suggests online sales under-performed expectations.

How about UPS and FedEx? Well, UPS went up 0.21% between Black Friday and November 30, and FedEx is up 0.87% in the same timeframe. Most of this growth begins Tuesday, November 29 - so clearly, Cyber Monday sales made a difference, but these numbers aren't exactly the 20% and 30% those articles were referencing.

Turns out, UPS is up this year mostly because they raised their dividend in May, turned in reliably growing performance all year, and then announced the acquisition of Marken on November 7, a life sciences supply chain company that will open up new business opportunities for them. FedEx's story is much the same - it beat market expectations with its quarterly earnings in March and September, seeing large price jumps at those times. Compared to the effects these events had on stock prices, both companies' end-of-November performance barely registers.

No one wants to write a story about how stock performance largely comes down to solid operations and good business models - it's so much flashier and exciting to talk about holiday sales and shopping events. But the market has thousands and thousands of analysts and investors trying to guess what those sales will be - its unlikely their consensus will be too far away from the truth.

Because the market is always trying to value the infinite future, long-term operational performance will always cause larger price movements than one-time events, and even surprises can leave investors unimpressed if they don't also change opinions about the company's future as a whole.

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In the two-week period following the 2016 election, the stock market rallied by 1.35%. Is this normal following a presidential election? We dug into the data to find out.

To do this, we tracked the closing value of the S&P 500 stock index on election day, then the closing value two weeks later, for a period from 1952 to 2016 (for 1952 to 1980, we used the last day the market was open before election day). Here are our results:

During the period, the average two-week performance of the market after the election of a Republican was 0.29%, and the average two-week performance of the market after the election of a Democrat was -0.81%.

What does this tell us? Well, for most elections, other than entertainment value, surprisingly little. The value of the stock market at any given time is a forward-looking measure, meaning that investors attempt to take into account all available information when making pricing decisions. That means that the likely outcome of an election has already been “priced in” to the market price. This is especially true in elections that aren’t especially close – a good example is 2008, for which the change in the S&P 500 is more likely related to prevailing market conditions (the worsening financial crisis) than any repricing of stocks based on a “surprise” election outcome.

The election of 2016, however, was a surprise outcome, and so we should expect that most of the price shift might be related to the reaction to the result. In this case, the market feels that Donald Trump’s policies will likely favor American businesses, leading to an increase in the value of those businesses by approximately 1.35%. This change in expectation is not uniform, however. Banks have done exceptionally well (Bank of America is up 7%; Goldman Sachs is up 6%; Citigroup is up 5%), which is likely a result of Republican promises to repeal the Dodd-Frank financial regulation; whereas gun-makers have fared much more poorly (Smith and Wesson is down 7%; Sturm, Ruger & Co is down 9%), as the market had expected consumers to “stock up” in the event of a Clinton election and is now pricing in lower future cash flows for these companies.

As in all things, stock prices are a constant game, with all participants trying to forecast future cash flows and determine what those cash flows are worth today. Incorporating new information – including events such as elections – is critical.

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This article originally appeared on Fortune Insiders.

Well, that hurt. Twenty years ago, I was standing in my commander’s office as he told me in muted tones that I had not handled something well. He was a leader I really looked up to, and knowing I had disappointed him made his delivery even more painful—I almost wished he would just yell.

About an hour earlier, during a tension-filled exercise, I had told his boss, in front of probably 50 others, to keep quiet while the team I managed tried to work out a problem in preparation for an intelligence satellite launch. I was a 26-year-old Air Force captain at the time. My boss was a 40-something colonel and his boss was a 50-something senior official from the CIA. Needless to say, the CIA manager was not happy with my calling him out during an exercise. And he let my boss know it.

The thing was, I was mostly right. The CIA official had broken with established protocol and my commander conceded this. But, he correctly pointed out, I wasn’t right in how I rebuffed the senior official publicly. I had made a big mistake, one that could be career-limiting. In that moment, I had visions of being drummed out of the military, with a dishonorable discharge for my indiscretion. What should I do?

I got lucky in that moment, and followed what I’ve since learned is the best path forward in such situations. First, I conceded that I had indeed screwed up. There’s no point in fighting when you mess up; doing so makes you look petty and insecure. That reaction will stick with your boss and those around you far longer than a discreet mistake will, even if it’s a big one.

Second, I asked what I could do to remedy the situation, offering first an apology to the senior CIA official. My commander said that wouldn’t be necessary—he would handle it—but he did say that I should acknowledge to those who worked with and for me that I had messed up. Offering to make amends immediately disarms those offended and helps rebuild valuable relationships. And making such acknowledgements to those who aren’t expecting them often has an even greater effect.

Third, I recounted in my own mind what had happened and replayed a scenario in which I had acted more appropriately. This helped me internalize a mental checklist, so that if a similar situation arose again, I would handle it better.

Finally, I found a way to reference my mistake in a self-deprecating manner in the weeks after. This is a delicate balance, since being too flippant can come off as arrogant. But making light of your own flaws can make you seem more human to those you interact with.

Unlike The Doors frontman Jim Morrison, who said, “Some of the worst mistakes in my life were haircuts,” you’ll likely have to deal with more substantial transgressions over your career. In these moments, your mistakes can feel deadly. But most of the time they’re not, and are more salvageable than you realize. Take a deep breath, and act deliberately and genuinely to make amends. You’ll live to fight another day.

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Disruptive innovation has been a buzzword since Clayton Christensen coined it back in the mid 1990s. But with everyone discussing disruption when it comes to each new business or product that emerges, how can we distinguish between new entrants that pose a threat and those that are best ignored?

Here are four key things to remember when assessing whether the next new company is likely to disrupt your business:

1. The common understanding of disruption IS NOT disruption according to Christensen

Let’s start with the basic understanding of disruption. According to Merriam Webster, disruption is “to cause (something) to be unable to continue in the normal way: to interrupt the normal progress or activity of (something).” If this definition is applied to business, then really anything that enters a market and is successful can be seen as “disruptive.” But is this how Christensen defined the word when writing in the 1990s?

A great article by Ilan Mochari discusses the misuse of the word disruption when referring to business. As he clarifies, disruption is “what happens when the incumbents are so focused on pleasing their most profitable customers that they neglect or misjudge the needs of their other segments.” 

2. Disruption can be low-end or new-market

These differences are laid out in Disruptive Strategy with Clayton Christensen. Low-end disruption refers to businesses that come in at the bottom of the market and serve customers in a way that is “good enough.” These are generally the lower profit markets for the incumbent and thus, when these new businesses enter, the incumbents move futher “upstream.” In other words, they put their focus on where the greater profit margins are.

New-market disruption refers to businesses that compete against non-consumption in lower margin sectors of a market. Similar to low-end disruption, the products offered are generally seen as “good enough,” and the emerging business is able to be profitable at these lower prices. The main difference between the two types of disruption lies in the fact that low-end disruption focuses on overserved customers, and new-market disruption focuses on underserved customers.

3. Christensen’s disruption is a process, rather than a product or service

When innovative new products or services – iPhone, Tesla’s electric cars, Uber, and the like – launch and grab the attention of the press and consumers, do they qualify as disruptors in their industries? Writing in Harvard Business Review, Christensen cautions us that it takes time to determine whether an innovator’s business model will succeed. He cites Netflix as an example that didn’t threaten Blockbuster at first – its DVDs-by-mail service didn’t satisfy the needs of customers who wanted to get their hands on the latest new release instantaneously – but, in shifting to an on-demand streaming model, was able to siphon away Blockbuster’s core customers before the company could stage an adequate response.

Will the next hot new launch be a flash in the pan, or a formidable competitor? Keeping a close eye on the process – is that product or service evolving its business model to better serve customers’ needs? – will help you evaluate the extent of the threat.

4. Choose your battles wisely

If you are a current incumbent and want to be on the lookout for a possibly disruptive emerging business, the clarification of what disruption is certainly helps. Every fire that is started doesn’t necessarily need to be put out, nor will it threaten your house. If you treat every fire as dangerous because someone else calls it “disruptive,” you will soon discover that it isn’t possible to put them all out, and you will waste your resources in attempting to do so. The fires you have to worry about are the ones that truly threaten you, and understanding the correct meaning and application of the word disruption certainly will help you in identifying and targeting the truly disruptive fires.

Understanding disruption is also helpful if you are looking for opportunities to start or scale your business. An understanding of disruption, coupled with Christensen’s other theory of "jobs to be done" can help you create products and services that will be desired by customers, and if you play your cards right, will be left alone by incumbents. 

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Want to learn more about disruption and other theories from Professor Christensen? Disruptive Strategy will equip you with the tools, frameworks, and intuition to make a difference.

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Let’s talk sunk costs. In business speak, a sunk cost is a payment or investment that has already been made. It can't be recovered and therefore shouldn't be a factor in decisions moving forward because no matter what, it can't be recouped. Businesses and organizations often have difficulty abandoning strategies because of the time spent developing them, even if they aren't the right choice for the company.

Imagine a company that decides to build a new factory. They already did their analyses and determined that the future benefit they will receive from the factory will outweigh the cost of construction. They pay for the factory up front and expect to earn a certain level of cash flows from the factory’s production each year. But after a few years, the factory is underperforming and cash flows are less than expected. 

A decision has to be made: should the factory be shut down or not? At this point, the initial cost of the factory is a sunk cost and cannot be recovered. The decision should only be based on the future cash flows—or the future expected benefit—of the factory compared to the value of selling the factory today, not the original cost of the factory.

However, sunk costs aren't just useful for large companies deciding whether to enter new markets or close down factories. This principle can be applied in everyday life, and understanding it may impact how you make decisions. 

Feel free to leave the baseball game if it’s raining.

Some may call you a fair weather fan, but the cost became sunk the instant you purchased your ticket. You might feel obligated to stay and stick it out if the ticket was expensive, but if leaving makes you happier, do it! Either way, you aren't getting your money back.

Don’t go to the gym just because you have an annual membership.

Working out may be advantageous to your health, but your annual membership shouldn't dictate whether you go to the gym on any given day. If you paid up front, that’s money you won’t see again—if you’d rather take a hike, watch a movie, or spend an hour trolling Snapchat, you should. Your annual membership isn’t coming back into your checking account either way. (Although, this is not to say there are no other benefits to working out.)

There's no need to clean your plate.

How many times have you been at a restaurant and felt compelled to finish your meal? What about dessert? You ordered it, so you have to enjoy it and eat as much as you can. Before you give yourself a stomach ache and ruin a perfectly enjoyable meal, let’s think about this in terms of sunk costs: you've already committed to paying for the dinner and dessert in front of you no matter how much you eat. If you are full or don’t like the taste, stop eating. It’s that simple.

Sometimes there is an emotional component to sunk costs.

Maybe you went to law school, passed the bar, started working, and then realized you hate being a lawyer. What should you do? You invested so much time, energy, and money in that degree, so it can't be worth starting over again with a new career, right? Unfortunately, these are all sunk costs, so if your end goal is your own happiness, you might need to cut your losses and refocus your energies elsewhere. 

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[Photo: Pat Greenhouse/The Boston Globe via Getty Images]

This post was originally published on Fast Company.

Business schools spend a great deal of time teaching would-be entrepreneurs and managers about the differences between features and benefits and their importance. Differentiate your product by tinkering with it to make it better or cheaper. Get to know your customer so you can understand how to sell to them.

Not exactly, says Harvard Business School professor and innovation expert Clayton M. Christensen. In his new book, Competing Against Luck: The Story of Innovation and Customer Choice, he and coauthors Karen Dillon, Taddy Hall, and David S. Duncan says that customers don’t buy products and services as such. Instead, they’re hiring them to do a job.

At first, that may seem like a very "insider baseball" distinction. Don’t you have to get to know your customer to understand their needs? Yes and no, Christensen says.

Product Or Service For Hire

Let’s say you have a customer who has a busy and stressful week at work. On Monday, after she walks through the door at 7 p.m., she exercises. On Tuesday, she pulls out a bottle of Jack Daniels and pours herself a drink. On Wednesday, she reads the Bible, and on Thursday, she uses her Xbox. If you’re trying to look at the customer’s attributes and connect the dots between these disparate activities and her overall behavior, it’s confusing. But when you realize that she’s "hiring" these various products to help her unwind, the picture becomes clearer, he explains.

"That's why you need to understand the situations that your customer finds themselves in," says Christensen. That's when they have a "job" and are more likely to buy your product, he says.

Companies that have embraced this model are able to innovate in ways that make it tough to compete. Christensen points to Airbnb as an example. The sleeping-space-for-hire company understands that customers may want to hire a hotel to do a number of jobs: to provide a room with a bed, present a suitable location for a meeting with an important client, or network with other people who are staying there. However, Airbnb is focused on providing a place where people can have a home base to sleep and not be bothered.

"When Airbnb emerged, they were focused on just one of these jobs, and they nailed it," he says.

The Benefits Of A Job Well Done

Such spot-on job performance has its benefits, the authors contend. When you have a deep understanding of the job, you can innovate more specifically to do it well. Rather than broadly guessing at what the customer might want, you can focus on innovation that addresses specific experiences they wish to have and deliver in a more focused manner. When you do that, you enjoy high levels of customer loyalty and repeat business and may even be able to command a premium price.

This offers a competitive advantage to any company that is willing to understand the job rather than the customer. For example, Amazon has turned shopping at disparate locations into a singular, streamlined experience where you can get a staggering number of products in one location and pay for them with one click. That deep understanding came from asking the right questions about the job to be done, Christensen says.

"Just in the shopping experience, if all they do is measure, ‘Did we ship it to you on time?’ That's a very different experience," he explains. Amazon took it a step further by asking, Christensen adds: "‘Did you receive it on time? What was it like to pay for the product, and how hard was it to find the product? What might I buy if I don't buy this? What else could I buy to get the same job done?'" Failure to do so could mean that businesses get better at the wrong things.

Disruption, Redux

This isn’t the first time Christensen has brought fresh thinking to the innovation arena. He coined the term "disruptive innovation" in 1995. It "describes a process by which a product or service takes root initially in simple applications at the bottom of a market and then relentlessly moves upmarket, eventually displacing established competitors." He addressed the topic again in his 2011 best seller The Innovator’s Dilemma: The Revolutionary Book That Will Change the Way You Do Business, and described successes and failures of companies like Intel, HP, and Honda in staying on top of their game.

Christensen, who is a member of the Church of Jesus Christ of Latter-Day Saints and open about his faith, says a practice in the Mormon church was part of the inspiration for his thinking about innovation, especially "jobs for hire."

He describes Mormon services delivered by fellow church members who talk about their own experiences. During the week, members have assignments to help each other. While many people feel the desire to help others but don’t know how to do so other than writing a check, Christensen has had to dive in to understand how people need help—in essence, the job that they needed to hire someone to help with, he says. The church's role is to provide that help in a way that strengthens peoples' faith.

"I have responsibility for several other families in our congregation," explains Christensen, "and my job is to be sure that if there are things going on that the rest of us can help with, we help them."

So if there is a measure of divine inspiration in Christensen’s latest book, perhaps it's the fact that we all have fundamental jobs we need done and are looking for the best product or service to fill them. Being the best answer/hire for that job ensures loyalty, whether you're providing retail goods, a place to sleep, or connection to a higher power.

The simplest model of a market involves two things, supply and demand, and the price and quantity of the goods sold in the market are a function of both. When a natural disaster hits, the immediate effect can be two-fold. In such situations, it is not unusual that the demand for certain products may increase. For example, if everyone is trying to leave the area, demand for gas may rise. The other effect is that supply for certain products may decrease. For example, it may be more costly to transport gas in areas affected by a natural disaster, thus decreasing the supply of gas and in turn, increasing the price.

When supply decreases, the price of the good increases. And when demand increases, again the price of the good increases. So we would predict that the market price of gas, for example, would increase in areas recently affected by a hurricane. And in fact we do see this.

Price-gouging occurs when companies raise prices to unfair levels. There is no rule for what qualifies as price-gouging, but it is not an uncommon occurance. For example, EpiPen costs and Uber price surges are both current examples of price increases that have been labeled unfair. 

Stories of price gouging in Florida after Hurricane Matthew have recently made headlines. Price increases due to natural disasters are the classic example of price gouging, and the government will usually intervene and directly prevent companies from doing so. But there can be unintended consequences to market interventions such as these, which explains the ongoing debate among economists and policy makers about the proper response to natural disasters and price gouging.

Want to read more about the price gouging debate?

• The Problem with Price Gouging Laws
  Harvard Business Review 
   
• Post-Sandy Price Gouging: Economically Sound, Ethically Dubious
  Time
   
• Why Economists Love Price Gouging, And Why It's So Rare
  National Public Radio

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This post was originally published on Linkedin Pulse.

The greatest achievement of John F. Kennedy’s presidency was resolving the Cuban Missile Crisis in the fall of 1962.

Agreement wasn’t a foregone conclusion. Kennedy himself calculated that the chance of a nuclear catastrophe was at least one in three, maybe higher. But he had learned a lot about negotiating from his failed summit talk with Soviet Premier Nikita Khrushchev a year earlier in Vienna. Those lessons still apply today. And they apply to everyday transactions.

First, Kennedy was agile strategically.

Among his own advisors, hawks argued strongly for immediate attacks on the missile sites being built in Cuba. Kennedy understood that military action might soon be necessary but he was determined to use the limited time available to pursue alternatives that wouldn’t trigger World War III. Imposing a blockade on Cuba (he called it a “quarantine”) was less provocative and gave him the chance to negotiate.

Second, he stress-tested his options by actively seeking counsel from experts with widely divergent views.

As a result, he avoided the “confirmation bias” trap, that is, being told only what others thought he wanted to hear. As a result, he fully understood the risks entailed in whatever path he might take.

Third, he used multiple channels of communication, instead of relying solely on formal messages telexed back-and-forth between Washington and Moscow.

Much later it was learned that Kennedy’s brother Robert (who was also Attorney General) held three secret meetings with Soviet Ambassador to the US, Anatoly Dobrynin. In these private sessions they floated proposals and developed a measure of personal trust.

Fourth, the President understood that the other side was not monolithic.

Just as with his White House advisers, there were hawks and doves within the Kremlin. He had to craft a resolution that would have sufficient support within both governments, but he didn’t have to please the hardest-to-please parties.

Fifth, Kennedy allowed Khrushchev to save face.

In return for the Soviets’ removing their missiles in Cuba, the president publicly pledged that the United States would never invade that country. Given the humiliating Bay of Pigs fiasco in 1961, there was little likelihood that the US would make another such attempt, but the guarantee gave the Premier something he could trumpet as a victory. My friend Bill Ury calls this tactic “building a golden bridge.” It enables a counterpart to justify an agreement to others (and also to himself).

Finally, Kennedy enriched the deal with a side agreement.

On the twelfth day of the standoff, with tensions mounting, Khrushchev sent a letter that made it seem that a deal was imminent. But then several hours later a more belligerent message appeared, with added demands, including insistence on US removal of Jupiter missiles it had installed in Turkey, bordering the Soviet Union.

That issue was potentially a deal-killer, as the Americans didn’t want to appear as if they were blackmailed into making a significant military concession. But it was suggested (apparently by Secretary of State Dean Rusk) that President Kennedy reply formally to the initial, more conciliatory Soviet proposal, and then have Robert Kennedy privately ask Ambassador Dobrynin deliver the written letter to Khrushchev along with an oral message to Khrushchev that the US missiles in Turkey would be withdrawn.

These six elements were all critical parts Kennedy’s negotiation strategy. They were bound together by a tough-minded appraisal of the situation. Like a chess master, Kennedy played both sides of the table, thinking several moves ahead, trying to anticipate how the Soviets might respond to American actions. He didn’t wish away the risks. He allowed for possible miscalculation on their part, rather than counting on them to respond “rationally” to the carrots and sticks he might deploy.

The same kind of tough-mindedness is essential in our own negotiations, even though far less is at stake. Having that attitude compels us to confront that whatever unfolds won’t be fully under our control. Whoever we deal with may be as determined—and fallible—as we are ourselves. Recognizing that reality compels us to be both agile strategically and creative in executing our plans.

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Gone are the days when people paid cash for the goods and services they needed. More often than not, companies (and individuals) prepay, or pay later for goods and services. The form of accounting that allows companies to keep up with these more complicated transactions is called Accrual Accounting.

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Accrual Accounting: An accounting method that recognizes revenue in the period in which it is earned and realizable, not necessarily when the cash is received. Similarly, expenses are recognized in the period in which the related revenue is recognized rather than when the related cash is paid.

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Accrual Accounting is helpful because it shows underlying business transactions, not just those where cash is involved. Most transactions that a company has are straightforward, with payment happening at the time of the transaction. Other, more complicated transactions, involve buying and selling on credit, which requires a company to account for monies that they will have to pay at a future date or receive at a future date.

Even more complicated are transactions that require paying for goods or services in advance or receiving money from customers in advance. The timing of when revenues and expenses are recognized related to these more complicated transactions can have a major effect on the perceived financial performance of a company.

How does all of this work in the real world?

Deferred Revenue

When a company receives cash before a good has been delivered or a service has been provided, it creates an account called deferred (or unearned) revenue. This account is a liability because the company has an obligation to deliver the good or provide the service in the future.

Suppose you paid a gym $1,200 on January 1, 2016 for a year-long membership. Using the accrual accounting method, the gym would set up a deferred revenue account (a liability) for the $1,200 to show that they had received the cash but not yet provided the service. As each month of 2016 passes, the gym can reduce the deferred revenue account by $100 to show that they have provided one month of service. They can simultaneously record revenue of $100 each month to show that the revenue has officially been earned through providing the service.

Prepaid Expense

When a company pays cash for a good before it is received, or for a service before it has been provided, it creates an account called prepaid expense. This account is an asset account because it shows that the company is entitled to receive a good or a service in the future.

Suppose that a dental office buys a year-long magazine subscription on January 1, 2016 for $144, so patients have something to read while they wait for their appointments. At the time of the payment, the dental office will set up a prepaid expense account for $144 to show that they have not yet received the goods, but they have already paid the cash. As each month of 2016 passes, the dental office can reduce the prepaid expense account by $12 to show that they have ‘used up’ one month of their prepaid expense (asset). They can simultaneously record an expense of $12 each month to show that the expense has officially incurred through receiving the magazine.

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