Accrual vs Deferral

Accruals and deferrals are important accounting concepts to familiarize yourself with when running any business.

Knowing the key differences between the two will enable you to keep accurate, consistent financial statements. 

In accrual accounting, sales and expense transactions are recorded when they are incurred, instead of when they are paid or received. Deferrals, on the other hand, are often related to an expense that is paid in one period but is not recorded until a different period. 

These concepts are not the easiest to understand, but with a thorough explanation, you can gain a deep understanding of both accruals and deferrals. In this article, we will take a deep dive into both financial concepts, explain the differences, and tell you how to record them. If you’re interested in learning more, then keep on reading!

What is an Accrual?

A deep understanding of accruals is necessary for proper financial reporting. So, we will begin by taking a close look at the definition of accruals and a few examples. 

As briefly mentioned earlier, accruals are financial transactions that are recognized when they occur. With accruals, you must get used to the idea of recording transactions before paying or receiving any money. 

The Accrual Method 

Accrual is not only a type of financial transaction, but it’s also a financial method that accountants and financial professionals abide by when completing regular bookkeeping. Under the accrual method, all revenue and expenses are supposed to be recorded whenever the transaction occurs. The benefit of this is, it better matches revenue and expenses within a period of time.

Accrual Examples

If your understanding is still a little fuzzy, don’t worry. We will go over some examples in this section to demonstrate some common accrual situations. 

• Revenue. As your company brings in revenue, under accrual accounting, you would record it immediately instead of when the customers actually pay for your product or service. 
• Employee wage payments. Under accrual accounting, you will record an employee’s wages as they are incurred instead of recording them when you pay them out. 
• Credit purchases. When a company purchases an asset on credit, even though payments will be made later on to the credit card company, that purchase should be recorded immediately. 

How to Record an Accrual

Understanding what accruals are is only half the battle- knowing how to record accruals is an entirely different beast. An accrual is recorded in a two-step process, which is a little different for revenues than it is for expenses. Let’s take a quick look at how to record accruals in your financial books. 

Record Accrued Expense

Accrued expenses, like business taxes, will be recorded as a debit to the accrued tax expense account and as a credit to the taxes payable account. 

Later on, when cash is paid to satisfy the expense, debit the taxes payable account for the amount you paid and then credit your cash account for the same amount. 

Record Accrued Revenue

Accrued revenue, like sales that have not yet been paid for, is first recorded as a debit to accrued revenue and a credit to your revenue account. 

Later on, when the payment for the product or service is paid for, the amount of the payment will be recorded as a debit to the accounts receivable account and as a credit to the revenue account for the same amount. 

What is a Deferral?

Now that you know what an accrual is, and you’ve read through a couple of examples, let’s get into deferrals. 

A deferral refers to the act of delaying the recognition of a transaction until a future date.

According to Investopedia, deferred revenue is the same as unearned revenue, where the money is received for a service or product that has not yet been provided. The revenue goes from unearned to earned whenever the product or service is provided to the customer. 

Deferred expenses are a bit different in that they are expenses incurred but not yet consumed. Oftentimes, deferred expenses are called prepaid expenses. 

Deferral Examples

For some, deferrals may be harder to understand than accruals. In the below list are some specific examples of deferral situations to help deepen your understanding of the concept: 

• Insurance policy expense. If you pay for an insurance policy in advance covering your business for six months, this expense will not be counted as an expense until at the end of the insurance policy. This is when the purchase will be counted as an expense.
• Unearned revenue. When you receive money in advance for services that you have yet to provide to the customer, this constitutes deferred revenue. Once the services are provided, or the product is delivered, then the unearned revenue will be recognized as earned income. 

Record Deferred Revenue

When recording deferred revenue, you should take the following steps. Once you receive the money, you should record a debit to your cash account for the same amount as the payment and then record a credit to deferred revenue. 

Once the product or service is provided, you should record an adjustment as a debit to deferred revenue and a credit to revenue for the payment amount. 

Note: If only a portion of a service is provided per pay period (which could be a milestone that’s worth a specified dollar amount), you should make the adjusting entry for the dollar amount of the milestone. 

For instance, if you plan to deliver a service worth $300 over three months in equal increments, you would divide the purchase amount up into thirds and record ⅓ of the purchase price ($100) in each pay period. 

Eventually, the entire purchase price will have been recorded as revenue. 

Record Deferred Expenses 

You’ll record deferred expenses in a specific way. When you pay a company for a service, you will record a debit to a prepaid expense account (depending on what type of expense it is) and a credit to your cash account. 

When the seller fulfills your order, delivers the asset, or provides the service, you will then record a debit to the expense account for the cost of the purchase and then a credit to the prepaid expense account. 

Differences Between Accruals and Deferrals

Now that you know the basics of accruals and deferrals let’s look at some of the differences between the two in the below table. 

Why Deferrals and Accruals Are Important

Accruals and deferrals are important because they enable you to record revenues and expenses that match. Understanding how to correctly classify and record accruals and deferrals is essential for accuracy in financial reporting. 

When compared to traditional cash accounting, accrual accounting is preferred because it gives business owners and financial staff the most accurate look at the business’s revenue and expenses. Deferral accounting allows you to keep better track of transactions in progress.

Final Thoughts

Now you know simple definitions of deferrals and accruals, examples of each, and how to record them in your financial journal. We hope that this article is helpful to you as you sort out your small business’s finances.