Accounting follows principles crucial in dictating the treatment of various transactions. Two of these principles include matching (or revenue recognition) and accruals. The matching principle states that expenses should get recognized in the same accounting period as the revenues they help generate.
On the other hand, the accruals principle states that revenues and expenses should be recognized when earned or incurred, regardless of the timing of cash inflows or outflows. Both of these principles can cause deferrals in the financial statements.
What is a Deferral in accounting?
In accounting, a deferral refers to postponing the recording of certain revenues or expenses in the financial statements. It is a mechanism used to match the recognition of revenues and expenses with the period in which they are incurred or earned, following the accrual basis of accounting.
Deferrals can occur in various forms. The most common of these include deferred revenues. The primary principle within these transactions is the difference between when they become recognizable and when they are due. Usually, the accounting for deferrals occurs in two stages. If these occur in two different accounting periods, they cause a deferral or accrual balance on the balance sheet.
What are the types of Deferrals in accounting?
Deferrals may occur in two areas, expenses, and income. Its type also dictates the accounting treatment for that area. Therefore, it is crucial to understand the types of deferrals.
Deferred expenses
These are costs or expenses paid in advance but have not yet been incurred or used. The payment is initially recorded as an asset and gradually recognized as an expense over time as the benefit is consumed or utilized. Examples include prepaid rent, prepaid insurance, or prepaid advertising. Usually, they appear as prepaid expenses on the balance sheet.
Deferred revenues
These are cash receipts or revenues received in advance for goods or services that have not yet been delivered or earned. This receipt is initially recorded as a liability and recognized as revenue when the goods or services are delivered. Examples include advance customer payments, unearned subscription fees, or prepaid service contracts. These appear as unearned revenues on the balance sheet.
Deferrals vs Accruals: What are the differences?
Deferrals and accruals are accounting adjustments to ensure revenues and expenses get recognized in the appropriate fiscal period. Here are the main differences between them.
Definition
A deferral refers to the recognition of income statement elements at a later point in time, usually when cash is obtained or paid. In contrast, an accrual involves the recognition of revenue or expense before the associated cash is received or paid.
Timing of recognition
Deferrals involve a delay in recognizing revenue or expense. The recognition gets deferred to a later accounting period when the cash is received or paid. On the other hand, accruals involve recording revenue or expense before the actual cash is obtained or paid. The recognition occurs in the accounting period when the income or expense occurs.
Journal entries
Deferral journal entries involve recording the cash transaction and adjusting the corresponding deferred revenue or deferred expense account over time until it is fully recognized. Accrual journal entries record the income or expense as it is earned or incurred, regardless of cash flow. They involve increasing or decreasing accrued revenue or accrued expense accounts.
Conclusion
Deferral is an accounting term to denote postponing the recognition of revenues or expenses. It usually occurs when a company receives cash before the related income or charge occurs. Typically, deferrals fall into two categories, deferred expenses, and revenues. However, they differ from accruals, where the settlement occurs after the related income or charge happens.
Originally Published Here: Deferral: Definition, Types, vs Accrual Accounting, Examples
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