What is a Deferral?

Accounting principles have the potential to throw anybody for a loop, and deferrals are no exception. Deferrals are among the most common concepts that accounting beginners struggle with, but a concrete understanding of deferrals is central to drafting accurate financial records. 

A deferral relates to a financial transaction amount paid or received, while the related service has not yet been performed or received. The purpose of an accounting deferral is to match the revenue or expense to the period the service is performed. Business owners may need to record a deferral transaction whenever a portion of revenue or expense should be applied at a later date. 

If you’re still not quite sure what a deferral is, that’s understandable. It’s pretty complex and fairly mind boggling in the beginning, but we’re here to help! This article will explain to you in detail what deferrals are and how to incorporate them into your accounting transactions. If you are interested in learning more, then keep reading!

What Exactly is a Deferral? 

Keeping accurate records is an essential part of business. Deferrals help you do just that. Matching payments or receipts to the period in which the service is performed creates accurate records. 

To keep things simple, a deferral refers to any money that you paid or received before the performance of a service. To break it down further, if you paid in advance for a service, or someone else paid you for a service that you haven’t yet received, then a deferral is in play. 

When deferral transactions are properly recorded in your financial statements, this increases the accuracy of your business’s recordkeeping. 

Types of Deferrals

Now that you know what a deferral is, let’s explore the different types of deferrals. There are two types of deferral transactions, and each serves a different purpose.  The two different types of deferrals are:

• Deferred revenue: Revenue that has been received before you’ve done any work or provided a service. Deferred revenue is considered a liability until it is delivered at which point it is recognized as revenue.
• Deferred expense: A deferred expense is an expense that has been paid but not yet incurred. The concept of a prepaid phone card is similar to this principle, as you have to pay upfront for an item or service that you have not yet consumed. Deferred expense is considered an asset until it is delivered at which point it is recognized as an expense.

Examples of Deferrals

As you may have gathered, deferrals are central to cultivating an accurate record of your business finances. If you need a bit more help understanding deferrals, maybe some common examples will give you a clearer picture. Below are some examples of scenarios that constitute a deferral situation. 

Deferred Expense Examples

Deferred expense transactions are common in small businesses, and we will cover a few of them here. 

Insurance Paid in Advance

If you pay for insurance to cover a few months in the future, the amount that relates to the future months is considered a prepayment and is recorded on the balance sheet as a prepaid asset. The prepaid asset is a deferred expense and is then recognized as an expense as the insurance policy is consumed. 

For instance, if you pay $2,400 in insurance premiums in July, which will cover your business until December, you will defer the cost and expense each month. The journal entries in your accounting records would look something like this:

Prepaid Insurance $2,400

Cash $2,400

(record the initial 6-month insurance premium payment on 7/1/20xx)

Insurance Expense $600

Prepaid Insurance $600

(recognize July insurance expense and reduce the prepayment on 7/31/20xx)

This second entry would continue each month as the insurance policy is used and would end on

December 31 as the policy expires.

Paying for Rent in Advance

If you pay your rent 3 months in advance, that rent amount will be treated as a prepaid asset until you complete the 3 months rental. The entries would look exactly the same as for the insurance except you might have an account for “prepaid rent” and “rent expense”.

Depreciation Over Time

When you purchase a tangible asset, like a company car or a machine for manufacturing, you will record the depreciation or usage of that asset over time using deferral accounting principles. Assume you purchased a high end graphics printer for $30,000 with an expected life of 5 years. The entries for this type of deferral would look as follows:

Equipment $30,000

Cash $30,000

(record the purchase of a graphic printer and record it as an asset on the balance sheet)

Since the high end graphics printer has a 5 year life you would depreciate it over 60 months and depreciate 1/60th of the cost each month ($30,000 / 60 = $500)

Depreciation Expense $500

Accumulated Depreciation $500

(record one months depreciation expense) 

Deferred Revenue Examples

Deferred revenue is the exact opposite of deferred expense as it relates to money you receive from a customer that you owe services too in the future. The following examples will demonstrate. 

Annual Subscription Payments

If your business charges for annual subscriptions, this calls for deferral revenue transactions. Money that you receive upfront for annual subscriptions will be deferred and then recognized on a monthly basis as you deliver the services until the subscription has been used up. 

The money received from the subscription payments does not technically count as revenue until the service is performed. At the end of each month, a portion of the subscription payment is recorded as income. Over time, the entire subscription payment will be recognized as revenue.

For instance, if you charge $1,200 a year for photo downloads at 10 downloads per month you would make the following entries.

Cash $1,200

Photo Subscription Deferred Revenue $1,200

(record the 12-month photo subscription receipt)

Photo Subscription Deferred Revenue $100

Photo Subscription Revenue $100

(recognize 1-month subscription revenue)

This second entry would continue each month until the subscription period was complete. Note that Photo Subscription Deferred Revenue is a liability and is recorded on the balance sheet as such. 

Revenue for Future Services

Another form of deferred revenue encompasses any service that you: 

• Receive an upfront payment for
• Are not immediately providing to the customer

For instance, when you sell your services to the client a month or so in advance, you will not immediately count that sale as earned revenue, being that you have not yet earned it (provided the service).

How to Record Deferrals

By this point, you should have a fairly good understanding of what deferrals are and some practical examples of journal entries required to reflect deferrals.

This last section here provides some general guidelines you can follow to make recording these transactions easy. 

Recording Deferred Revenue

Accuracy is key in record keeping, but it doesn’t have to be complicated. Deferred revenue will not be recorded on your income statement, as it is not considered income. When you receive deferred revenue, here are the steps.

• Record the Deferred Revenue. Since you received cash you will debit “Cash” with a corresponding credit to a “Deferred Revenue” account which represents a liability or an amount you owe. 
• Calculate your monthly earned revenue. Simply divide the amount received by the number of months covered to calculate the amount that will be earned each month. For a one year period you will divide by 12. 
• Record your earned revenue. Every month, record the monthly amount calculated above. Simply debit the “Deferred Revenue” liability account and credit the “Revenue” account.

Recording Deferred Expenses

Deferred expenses are recorded the exact opposite. The following steps will help give you a basic description. 

• Record the deferred expense as an asset. To do this, debit the “prepaid asset” account and credit “Cash” for the same amount. A deferred expense is considered an asset until the service has been delivered. 
• Record the Expense. Once the services are consumed, then record the expense as an actual expense by crediting the “prepaid asset” account and then debit the “expense” account for that same amount.

Final Thoughts

Now you know what a deferral is, you’ve learned about some common deferral situations, and you know how to record deferral transactions. We hope that this article is useful to you in your small business accounting endeavors!