One of my clients is providing a small amount of free labor to their customers. They have recognized a liability for the portion of labor that was promised but not yet delivered to the customer, and simultaneously recognized a corresponding expense. When the labor is actually provided, what should the journal entry be?

The liability decreases, but is the expense reversed? We will not receive any payment or compensation, so there is no accounts receivable or cash, and I am having difficulty determining what the other side of the entry should be.

Core Issue Analysis

This issue involves the accounting treatment of free labor, and the key lies in distinguishing the nature of the "recognized liability" from the "recognized expense." Based on the description, the client recognized a liability (credit) and an expense (debit) at the time of the promise, which is similar to the recognition of an accrued expense or a contract liability. When the labor is actually provided, the liability should be settled (debited to decrease), but whether the expense is reversed depends on whether the expense is an accrued item that has been "incurred but not paid" or an amortization of a "prepaid cost."

Two Possible Scenarios

  • Scenario 1: The expense is an accrued liability (e.g., employee compensation payable)—If the initial entry is: debit expense, credit liability (e.g., labor fees payable), then when the labor is actually provided, the liability decreases (debit liability), and the original expense should be reversed (credit expense), because the expense has not actually been incurred (the labor is free, with no cash outflow). In this case, the entry is: debit liability, credit expense.
  • Scenario 2: The expense is an accrued performance cost—If the initial entry is: debit expense (e.g., prepaid cost), credit liability (e.g., contract liability), then when the labor is actually provided, the liability decreases (debit liability), and should revenue be recognized or cost be reduced? However, there is no revenue here, so the expense should be reduced (credit expense) to bring it to zero.

In either scenario, since no cash or accounts receivable is involved, the other side of the entry should be a reversal of the expense (credit), i.e., reducing the originally recognized expense. This way, the net impact is zero, consistent with the principle that free labor does not generate profit or loss.

Specific Journal Entry Recommendation

Assume the initial entry is:

Debit: Labor expense (or related expense account)
Credit: Labor fees payable (or provision liability)

When the labor is actually provided, the recommended entry is:

Debit: Labor fees payable (or provision liability)
Credit: Labor expense (or related expense account)

This entry simultaneously reduces the liability and reverses the expense, without involving cash or accounts receivable, and aligns with the economic substance of free labor.

Notes

  • If the expense was initially recognized in a period expense (e.g., administrative expense), the reversal should also reduce the same account to avoid cross-period mismatches.
  • If the labor provision spans multiple periods, the liability and expense should be adjusted based on the progress of performance, but since free labor typically does not involve revenue recognition, the expense should ultimately be brought to zero.
  • It is recommended to confirm with an auditor or tax advisor, as different standards (e.g., IFRS or GAAP) may have special provisions for free labor, but based on the description, the above treatment complies with the accrual basis principle.

In summary, when free labor is provided, the liability decreases and the expense should be reversed; the other side of the entry is the expense account (credit), with no need to recognize any asset or revenue.