A business that provides goods or services before it collects cash recognizes accounts receivable. Some businesses are in the fortunate position to be able to demand cash payments in advance of providing goods or services. For example, building lessors typically require a month’s rent in advance and insurance companies collect cash premiums covering a year in advance.
In accrual accounting a business receiving payments in advance incurs a liability called deferred revenue at the time of cash collection. This liability is the obligation to provide the goods or services that are already paid for. The obligation is discharged and revenue recognized only after the business delivers the good or services.
If a business pays for goods or services before they are actually delivered, an asset called prepaid expense is recorded when payment is made. An actual expense is recognized and recorded only after the goods or services are delivered.
Example. Recall Joint Ventures had to pay Hurt’s Plane Rental $9,000 in December 2004 in advance for a three-month plane lease. If a cash basis of accounting is used, all $9,000 is recognized as a December expense. Using an accrual basis of accounting better reflects economic reality because only $3,000 will be recognized as December expense. The other $6,000 will be recognized as expenses in January and February of the following year. When Joint Ventures pays Hurt’s $9,000 on December 1, the transaction is recorded like this:
An asset, Prepaid Expenses, is increased and another asset, Cash in Bank, is decreased. Assuming Hurt’s Plane Rental utilizes an accrual basis of accounting, they record a liability when they receive Joint Ventures’ payment. On their books the transaction looks like this:
A liability is recognized by Hurts because as of December 1 it still has to deliver three months’ worth of plane use to Joint Ventures. The key point is that Hurts does not recognize revenue, nor does Joint Ventures recognize expense at the time cash changes hands. Only after an actual service is delivered is revenue and expense recognized. When does this happen?
In this situation the service in question is the leasing of a plane. At the end of December Joint Ventures will have had one month’s use of the plane. So at the end of December the following entry on Joint Ventures’ books is made to reflect the rental expense for that month:
Notice that the rental expense account for the month would have a $3,000 debit balance and the Prepaid Expense account would have a $6,000 balance. In January and February of 2005 similar entries have to be made to properly reflect the correct plane rental expense for these months.
At the end of December the following entry is made in Hurts’ books:
Again, similar entries will be made at the end of January and February.