3. Accruals and Deferrals

Let's talk about accruals and deferrals. Now, a quick little thing to remember: deferral, cash first. Accrual, cash later. Okay, that doesn't mean anything to you right now, but it will. Let's look at four scenarios. One, we pay cash upfront for one year of rent. Okay? Second scenario, employees work for two weeks before they're paid. That makes sense, right? That's how most places work. You work for two weeks, and then you get paid for the two weeks that you worked for. Another one, let's say we get paid for services to be completed. So this means we haven't done the services yet, but they're to be completed.

So we get paid ahead of time. So we get paid up front for services to be completed. And a fourth one, fourth one's gonna be the opposite. We perform services, and we get paid later. Okay? So we're gonna use these four examples to try to figure out what accruals and deferrals are.

Okay, so we pay cash up front for one year of rent. So rent to us is an expense. We're paying to rent out a building, and we pay cash up front. But if you'll remember from the expense recognition video, we haven't really incurred this expense yet, right? If we pay on January 1, and our lease, where we paid for a full year, we paid right here, we're still looking forward to the use of the building for the entire year. We haven't incurred any of that expense. Now, on July 1, we'll be looking back on six months of expense and forward to six months of using the building still.

But if we're talking about January 1, we have a whole year of looking forward to use the building. So we know that it's not an expense on January 1 when we pay it. Right? The journal entry for January 1 is gonna look like prepaid rent and cash.

And the reason it's not an expense is 'cause we haven't used it up. So this is an asset, and this is an asset, so we're just swapping assets around because we haven't actually incurred the cost yet. So this one is a deferred expense. Because we've already paid for it and later it will be an expense once we use it up, we call it a deferred expense. And a deferred expense is actually an asset, and here's why. Because on January 1, we've got this $12,000 deferred expense. That is a probable future economic benefit. Right? So we're standing here on January 1, and in the future we're gonna get the benefit of all of this time to be in the building, right?

That's what rent is. You're paying for time in a building. And so because it's a probable future economic benefit, deferred expenses are assets. Prepaid rent is an asset because it's rent that you don't have to pay in the future because you've already paid it, so it's a probable future economic benefit.

Okay, employees work for two weeks before they are paid. So if employees are working, we're incurring that cost, right? But there's no cash involved in this scenario at all. Employees work for two weeks before they are paid, so there's no cash involved. So if employees work for two weeks, and that's $2,000, we incurred that cost. So we have wages expense, 'cause it doesn't matter when we pay. It's an expense when we incur it. So we have wages expense, and we'll call it wages payable. So this is the journal entry for number two. We have wages expense of $2,000, and we have wages payable of $2,000.

Just because we didn't pay it doesn't mean it's not an expense. When we do pay it, we'll take down our payable by $2,000, and we'll take down our cash by $2,000. Right? So this would be the adjusting entry, which we'll go over later. The important part is here, we incurred the expense of those employees working. They did the work. We owe them the money.

So this one is an expense that we've already incurred, and we're just accruing it. We're just adding it up. So this one is an accrued expense. It means we haven't paid yet. The money comes later. We haven't paid yet, but we've already incurred it, so we're just adding it in.

And since we're gonna have to pay them in the future, that represents a liability to us. So this is an accrued expense. You can think of it kinda like a bucket. So if you've got a bucket and you've got, we'll take our example, you've got wage expense.

You've got wage expense, and each week the employees work, we're incurring expenses, right? They're doing the work. We owe them the money, but we may not pay them until much later. So this right here is called wages payable, and you can see all we're doing is we're accruing expenses. We're adding expenses into this bucket, so this is an accrued expense. Okay? And then when it comes time to pay the employees for their work, that's not another expense. We're just paying what is able to be paid. We're paying the payable.

So then when we pay it, we're just draining this accrued expense, right? So we're paying with cash, and we're taking it out of the accrued expense. So wage expense that we haven't paid, we're dumping into the bucket. Then when it comes time to pay it, we're draining the bucket and paying them with cash. So had we done it all at the exact same time... Let me show you. So wage expense of $1,000, and we put it into that payable at $1,000. Then we reduce the payable by $1,000 when we pay it with cash at $1,000. So you'll notice something. This guy and this guy cancel each other out.

So what we're dealing with here is basically an expense and paying that expense, but it's offset in time. So we record it when we incur it, but if we didn't have to do that, it would just be this one journal entry right here. So this is just an intermediary step, and if it wasn't for the whole expense recognition principle, the matching principle, all that garbage, we could just record these at the exact same time. We'd say, "Okay, well, we paid, so that must be an expense." But because we're doing accrual accounting, we have to accrue all that stuff when we actually incur it. Then when we pay it, we just drain the payable by using cash.

So what we end up with, instead of using this one nice compact journal entry of wages expense and cash, we're separated in time enough that we go through this intermediary step. So this may be, I don't know, two weeks apart. So we put it into this payable until we're ready to pay it, and then we pull it out of the payable and pay it with cash. It's a pretty good bucket.

Okay, let's look at this one. We got paid for services to be completed. So we got cash up front, and we haven't done any work. So that journal entry is gonna look like this. We get cash. Let's say we get $1,000 cash, but we haven't done any work, so it's not really a revenue as much as it is an unearned revenue.

So it's an unearned revenue, meaning at some point we're gonna have to earn it. So really, this is kind of a liability for us. We got paid for something that we didn't actually do, and later we're gonna have to actually do it.

So for this one, this is a deferred revenue, and it's a deferred revenue because we are deferring it until we earn it. Right? We can't say we earned the revenue until we actually do the work. Now, so let's say this is 1/1 and this is 1/15. When we come back and do the work, we get to decrease our unearned revenue. We're basically just undoing it. So we're gonna put it on the opposite side as we did the first time, and we get to increase our revenue. And you'll notice, just like this example over here where the payable just kinda goes away once you combine these two journal entries, that's exactly what happened over here.

We have unearned revenue. We credited it for $1,000, and then when we did the work, we debited it, and so we end up with nothing. So had we done the work at the same time that we got paid, unearned revenue wouldn't even be in the picture. We'd just have this nice clean journal entry right here. But because doing the work and getting paid were separated in time, we have to put it into this holding pattern right here. We put it into unearned revenue until the time comes where we actually do the work. Then we take it back out of unearned revenue and get to recognize the revenue.

So this one is a deferred revenue. We're not recognizing the revenue. We've deferred the recognition until later. Okay, last one. We perform services and get paid later. Let's find a place to do this journal entry. So we perform services and get paid later. So we know that the first journal entry on January 1 is not gonna have cash in it because we're gonna get paid later. So we're going to accrue. We're gonna say this is an account receivable. We should have gotten paid for it, but for whatever reason we didn't and so we're gonna get paid for it later. So that's an account that we're able to receive, but we did the work, so we're gonna go ahead and recognize the revenue.

And since we get paid later, let's look at that. On the 15th when we actually get paid, let's say our cash increases by $1,000 and our accounts receivable decreases by $1,000. And so this is the same journal entry right here as doing work and getting paid at the same time. Right? You get paid $1,000 and you get to recognize it immediately. But again, we're separated in time. We did the work two weeks ago on the 1st, but we didn't get paid until the 15th. So we don't get to record them as one journal entry. We have to put it into this account receivable 'cause we didn't actually get paid for it.

Then when we do get paid for it, we just take it right back out. So this account receivable right here, this guy, it's kind of just a holding pattern while we're waiting to get paid cash. So this one is just an accrued revenue.

And an accrued revenue is an asset 'cause we're gonna get the cash later, and a deferred revenue is a liability 'cause we have to do the work later. Now, we'll do a couple of other videos just working through examples on this kind of stuff, but let's do a quick recap.

Accruals, the cash comes later. Deferrals, the cash comes first. So you may be confused here when we say deferred, and then we put first, and we say accrued, and we say later. So you'll have to remember that in accrual-based accounting, cash doesn't really matter that much. So if we get cash first, what we're deferring is the revenue or the expense, and if we get cash later, what we're accruing is the revenue or the expense. So break your habit of trying to think of everything in relation to cash. What we're trying to think of is in relation to revenue and expenses.

So if we get cash before anything happened or we pay cash before anything happened, we know that the event is deferred. Something must happen after we get the cash. Cash first, event later. If we're accruing it, we know that the event happened, and then we're getting cash. So let's look at these. We pay cash upfront for a year of rent. Cash first, and then we use the building for a year. So the event came after the cash, so that's a deferred expense or a prepaid expense. Employees work for two weeks before they're paid. The event happened, their working happened, and then we paid them, so that's an accrued expense because we owe them for the work that they did.

We get paid for services to be completed, so we got paid upfront, and then later we're gonna do the work of actually earning that revenue, so this is a deferred revenue. We perform services and get paid later. Well, the event happened first. We perform the services, and then we get paid, so what we've done is we've accrued the revenue.