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.
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.
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?
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.
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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About the Author
Christine is a member of the HBX Course Delivery Team, focusing on Financial Accounting and Disruptive Strategy. She holds a B.S. in Management from UNC Asheville, an M.S. in Accounting from Northeastern University, and an MBA from Northeastern University. In her spare time, she enjoys reading business journals and watching NFL games.