A cost is an outlay of cash in exchange for something of value. A cost could be an asset or expense. Earlier we discussed the characteristics of an asset and one characteristic of an asset is that it has a future value.
An expense on the other hand is a cost whose usefulness is consumed shortly after purchase. For example, when you buy an ice cream cone, the second you eat it, the ice cream fails to exist. Another way to put it is there is no future value. Examples of expenses in business are rent, utilities, wages, etc.
Converting assets to expenses
So what happens when a cost is not immediately consumed but is used for future revenue production? When this happens a cost is classified as an asset. Assets that arise from a cost to the business eventually show up in the profit and loss statement as an expense after they are used in the revenue production process. Another way to define assets that arise from costs is delayed/ deferred expenses. An example of an asset that is slowly recognized in the profit and loss statement over time is depreciation expense. We will talk more about depreciation in a later lesson.
Accruing and deferring expenses
Previously we talked about the recognition and realization principle. When cash is received or spent before an event occurs, we defer the revenue or expense recognition until the corresponding event takes place.
On the other hand, when cash is received or spent after the event occurs, we accrue the revenue or expense.
Receiving cash before revenue is recognized
Mary paid Jo Inc. $2000 for consulting services three months for now.
Jo Inc. must defer the revenue because the event has not occurred. The account used to hold revenue that has not been earned is called “unearned revenue” and it is a liability account. Jo Inc. still owes Mary consulting services so has a liability
Mary also received $500 of consulting services in the current month but promised to pay one month from now.
Jo Inc. must accrue the revenue because the event has occurred. The account used to hold the receivables for revenue that has been recognized is “accounts receivable“. This is an asset account. Jo Inc. has earned the right to the cash. This cash is a future benefit to Jo Inc. Therefore, Jo Inc. has an asset.
Jo Inc. paid Jay-Jay $300 for consulting service to be performed 3 months from today
Jo Inc. must defer the expense i.e. recognize the expense in a future period. Even though cash has been collected, the event has not occurred. Deferred expenses are normally classified in a “prepaid expense” account. This is an asset to the business because the business still has future rights to the service it has paid for.
Jay-Jay also worked for Jo Inc. and Jo Inc. will not pay Jay-Jay till one month from the day the job is completed.
Jo Inc. must accrue the expense, because the event has taken place. Accrued expense are normally classified in a “payables account“. In his case the payables account will be “wages payables“. Payables account are liability accounts because this is money the business owes to outsiders for services performed.
The Matching Principle
In the examples above, we deferred or accrued expenses or revenue regardless of when the cash collection or payment took place.
Why is the accrual or deferment of expenses important?
To have a better understanding of why, let me give an example. Assume you hosted a banquet in March. The banquet brought in $1000 in revenue. However all of the expenses needed to host the banquet occurred in February. The total expense was $500. If you were to print a profit and loss statement in March it will look like you made $1000 with no expenses. However, you know the banquet cost you $500. The matching principle is an accounting principle that solves the problem. The matching principle says expenses should be deferred or accrued to match its corresponding revenue regardless of when cash is received.
You pay your landlord rent one year in advance. There is still future value in the cost you incurred so the rent you paid is an asset. When you pre pay an expense it is called a prepaid asset. In this case the expense we are talking about is rent so we can name the account prepaid rent.
There are some expenses that cannot be matched directly to sales and matching revenue to expenses can be somewhat difficult. These types of cost are called period costs because they are matched with the period they happen and not their period rather than revenue.
Some examples of period cost are:
- Advertising expense
- Salary of executive staff
- Employee training
- Human resource expenses