Understanding the basics of accounting is vital to any business’s success. Under the accrual basis of accounting, recording deferred revenues and expenses can help match income and expenses to when they are earned or incurred. This helps business owners more accurately evaluate the income statement and understand the profitability of an accounting period. Below we dive into defining deferred revenue vs deferred expenses and how to account for both. Show
Deferred revenue is money received in advance for products or services that are going to be performed in the future. Rent payments received in advance or annual subscription payments received at the beginning of the year are common examples of deferred revenue. Deferred expenses, also called prepaid expenses or accrued expenses, refer to expenses that have been paid but not yet incurred by the business. Common prepaid expenses may include monthly rent or insurance payments that have been paid in advance. Accounting for Deferred RevenueSince deferred revenues are not considered revenue until they are earned, they are not reported on the income statement. Instead they are reported on the balance sheet as a liability. As the income is earned, the liability is decreased and recognized as income. Here is an example for a $1,000 payment for services that have not yet been performed: In this transaction, the Cash (Asset account) and the Unearned Revenue (Liability account) are increasing.
Once the services are performed, the income can be recognized with the following entry: This entry is decreasing the liability account and increasing revenue.
Why is deferred revenue considered a liability? Because it is technically for goods or services still owed to your customers. Accounting for Deferred ExpensesLike deferred revenues, deferred expenses are not reported on the income statement. Instead, they are recorded as an asset on the balance sheet until the expenses are incurred. As the expenses are incurred the asset is decreased and the expense is recorded on the income statement. Below is an example of a journal entry for three months of rent, paid in advance. In this transaction, the Prepaid Rent (Asset account) is increasing, and Cash (Asset account) is decreasing.
Once one month of the expense has been incurred, the expense can be recognized with the following entry: Here we are decreasing our Prepaid Rent and increasing our Rent Expense on the income statement.
Under the cash basis of accounting, deferred revenue and expenses are not recorded because income and expenses are recorded as the cash comes in or goes out. This makes the accounting easier, but isn’t so great for matching income and expenses. Learn more about choosing the accrual vs. cash basis method for income and expenses. To discuss how we can best assist you and the associated fees, contact an Anders advisor below. All Insights Expenses that are recognized even though cash has not been paid What are Accrued Expenses?Accrued expenses are expenses that are recognized at the time they are incurred, even though cash has not yet been paid. These expenses are paired up against revenue via the matching principle from the GAAP (Generally Accepted Accounting Principles). For those who are unaware of the matching principle, it states that you record revenues and all related expenses in the accounting period in which they occur. This is true regardless of whether or not cash has actually been received by the seller or paid out by the buyer.  Types of Accrued ExpensesThere are different types of accrued expenses. However, in this article, we focus on the more common accrued expenses that you will run into as an accountant from time to time:
In demonstrating and showing examples of accrued expenses, we are using MS Excel. If you are unfamiliar with Microsoft’s spreadsheet program, be sure to check out our free Excel crash course. Accrued Salaries and WagesThis type of accrued expense is very common and occurs regularly within company operations. Following is an example to demonstrate how and when this type of accrued expense may occur. ExampleCorporate Finance Institute pays salaries of $58 per day in a 5-day work week every week. The last time employees were paid was on June 30, Friday. Unfortunately, due to statutory holidays occurring in the preceding week (Monday and Tuesday), employees were only paid for Wednesday, Thursday, and Friday. It means management needed to prepare adjusting entries to recognize employees have only been paid three days out of five. This is the entry that management would record: Notice that on Friday, July 7, management would record the recognition of the accrued salaries expense. This is the salaries that have accrued over the three days, which can be found through some math: (58/5)*3. Now, when the company reaches the end of their 5-day work week, which lands on Tuesday of next week, July 11, management records the payment of the salaries. This is shown in the second entry by debiting the salaries and wages payable account by the amount that was accrued and debiting the salaries expense account. We also credit cash to demonstrate that cash was paid for salaries. Note that salaries payable is similar to accounts payable. Accrued InterestAccrued interest is another type of accrued expense that is common for companies with notes payables. Notes payables are promissory notes issued by either an individual, banks, or even other companies that obligate the issuing party (the one who must pay it back) to pay back the amount stated by a certain date. Just like earlier with salaries and wages, we use an example to demonstrate what we mean. ExampleOn January 1, Corporate Finance Institute issued a 1-year promissory note to AC Bank. The terms of the promissory note were a $10,000 value along with an annual interest rate of 2%. Because the note was for a term of one year, the maturity date of the note would be December 31 of the present year. These are the journal entries that the company would record: The very first entry on January 1 is the recording of the issuance of the note. Recall that the note’s face value was $10,000, with an annual interest of 2%. The next entry on February 1 records the accrued interest for the month of January. We record interest every month to recognize the monthly interest that we are obligated to pay. All this monthly interest eventually adds up to the annual interest amount at the end of the year. To record the monthly interest expense, we take the face value of $10,000, multiply it by the annual interest rate of 2%. This gives us $200, which is our annual interest. We then divide this annual interest by 12 (200/12), and we end up with $16.67. This will be the monthly interest that we record every month leading up to the last month, when we actually pay the interest due. The last entry represents the payment of the note, along with all interest that has accrued over the life of the note. Again, we see that there is a debit of interest payable along with a debit of interest expense. This is done because we are paying off all of the accrued interest along with the last bit of interest that accrues in December. An important thing to note is that debits must always equal credits. Otherwise, issues can arise in your financial statements, especially in the balance sheet and income statement, because these two statements are closely related to one another. Learn MoreCFI is the official provider of the global Commercial Banking & Credit Analyst (CBCA)® certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional CFI resources below will be useful:
What are the effects on the financial statements of failure to take up accrued expenses?Answer : Net income is overstated and liabilities are understated.
What happens when you fail to record an accrued revenue?The absence of accrued revenue would tend to show excessively low initial revenue levels and low profits for a business, which does not properly indicate the true value of the organization.
What happens when accrued expenses are not recorded?If an accrued expense is not recorded in the appropriate month, expenses on your income statement will be too low, as would the accrued liabilities that appear on your balance sheet.
What is the effect on the financial statements when a company fails to accrue revenue earned at year end quizlet?What is the effect on the financial statements when a company fails to accrue revenue earned at year-end? Net income is understated and assets are understated.
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What are the effects on the financial statements of failure to take up accrued expenses accrued revenues?
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