Generally accepted accounting principles (GAAP) require businesses to recognize revenue when it’s earned and expenses as they’re incurred. Often, however, the timing of a payment may differ from when it’s received or an expense is made, so accrual and deferral methods are used to adhere to accounting principles.
Accrual basis accounting is generally considered the standard way to do accounting. The Security and Exchange Commission (SEC) requires all public companies to use accrual basis accounting and comply with GAAP to provide consistency and transparency of reporting for investors and creditors to evaluate businesses.
Accrual vs. Deferral
So, what’s the difference between the accrual method and the deferral method in accounting? Let’s explore both methods, walk through some examples, and examine the key differences.
Accrual vs. Deferral: Key Differences
Here are some of the key differences between accrual and deferral methods of accounting.
- Accrual: Items that occur before payment and receipt.
- Deferral: Occurs after payment or receipt of revenue.
- Accrual: Accrual expenses are incurred, but have yet to be paid (such as accounts receivable).
- Deferral: Deferred expenses that are paid, but have yet to incur expense (such as pre-paid accounts).
- Accrual: There’s no payment of cash.
- Deferral: There’s an advance payment of cash.
- Accrual: Accrual revenue is revenue that is earned, but has not yet been received (such as accounts payable).
- Deferral: Deferred revenue is revenue that is received, but not yet incurred (such as a deposit or pre-payment).
Expense vs. Revenue
- Accrual: There’s a decrease in expense and an increase in revenue.
- Deferral: There’s an increase in expense and a decrease in revenue.
An accrual system recognizes revenue in the income statement before it’s received. A deferral system aims to decrease the debit account and credit the revenue account.
What is Accrual?
Using the accrual accounting method results in the following:
- Accrued expenses are reported now while payment of the expense comes later.
- Accrued revenues are reported at the time of sale but you’re waiting on payments.
What is Deferral?
Using the deferral accounting methods results in the following:
- Deferred expenses are paid for now but reported in a later accounting period.
- Deferred revenue is received now but reported in a later accounting period.
An accrued expense is one that you’ve incurred, but have yet to pay. For example, you’re liable to pay for the electricity you used in December, but you won’t receive the bill until January. You would recognize the expense in December and then when payment is made in January, you would credit the account as an accrued expense payable.
A deferred expense is paid in advance before you utilize the services. For example, you pay property insurance for the upcoming year before the policy is in effect. You would recognize the payment as a current asset and then debit the account as an expense during each accounting period.
Example of Expense Accrual
An example of expense accrual might be an emergency repair you need to make due to a pipe break. You would hire the plumber to fix the leak, but not pay until you receive an invoice in a later month, for example. The liability would be recorded by debiting expenses by $10,000 and crediting accounts payable by $10,000.
When the bill is received and paid, it would be entered as $10,000 to debit accounts payable and crediting cash of $10,000.
Example of Deferred Expense
An example of a deferred expense would be you pay upfront for services. While the payment has been made, the services have yet to be rendered. You would record this as a debit of prepaid expenses of $10,000 and crediting cash by $10,000.
When the services have been completed, you would debit expenses by $10,000 and credit prepaid expenses by $10,000.
When you note accrued revenue, you’re recognizing the amount of income that’s due to be paid but has not yet been paid to you. For example, you make a sale in March but won’t receive payment until May. You would recognize the revenue as earned in March and then record the payment in March to offset the entry.
Deferred revenue is money you receive before earning it. For example, a client may pay you an annual retainer in advance that you draw against when services are used. In this case, the revenue is not recorded until it is earned. It would be recorded instead as a current liability with income being reported as revenue when services are provided.
Example of Revenue Accrual
An example of revenue accrual would occur when you sell a product for $10,000 in one accounting period but the invoice has not been paid by the end of the period. You would book the entry by debiting accounts receivable by $10,000 and crediting revenue by $10,000.
When the bill is paid, the entry would be adjusted by debiting cash by $10,000 and crediting accounts receivable by $10,000.
Example of Deferred Revenue
Let’s say a customer makes an advance payment in January of $10,000 for products you’re manufacturing to be delivered in April. You would record it as a debit to cash of $10,000 and a deferred revenue credit of $10,000.
The receipt of payment doesn’t impact when the revenue is earned using this method. When the products are delivered, you would record it by debiting deferred revenue by $10,000 and crediting earned revenue by $10,000.
The Importance of Accrual and Deferral
Accrual and deferral methods keep revenues and expenses in sync — that’s what makes them important. In accounting, deferrals and accrual are essential in properly matching revenue and expenses.
Using these methods consistently helps someone looking at a balance sheet understand the financial health of an organization during the accounting period. It also helps company owners and managers measure and analyze operations and understand financial obligations and revenues. By using these methods and following GAAP, investors and other stakeholders are also able to better evaluate a company’s financial health and compare performance against competitors.
An accrual basis of accounting provides a more accurate view of a company’s financial status rather than a cash basis. A cash basis will provide a snapshot of current cash status, but does not provide a way to show future expenses and liabilities as well as an accrual method. Similarly, in a cash basis of accounting, deferred expenses and revenue are not recorded. Expenses and income are only recorded as bills are paid or cash comes in.
The key benefit of accruals and deferrals is that revenue and expense will align so businesses can account for all expenses and revenue during an accounting period. If businesses only recorded transactions when revenue is received or payments are made, they would not have an accurate picture of what they owe and what customers owe them.
This method of accounting also tends to smooth out earnings over time. For example, using the cash method, an eCommerce company would likely look extremely profitable during the holiday selling season in the fourth quarter but look unprofitable during the first quarter once the holiday rush ends. Neither measure tells the entire story. In cash accounting, you would recognize the revenue when it comes in (during Q4) but not the expense for the products you purchased until you paid for them, which might not be until Q1 of the following year. Using the accrual method, you would account for the expense needed in pursuit of revenue.
Frequently Asked Questions About Accruals and Deferrals
Here are some common questions and answers concerning accruals and deferrals.
What is the basic difference in accrued and deferral basis of accounting?
The basic difference between accrued and deferral basis of accounting involves when revenue or expenses are recognized. An accrual brings forward an accounting transaction and recognizes it in the current period even if the expense or revenue has not yet been paid or received. A deferral method postpones recognition until payment is made or received.
Is prepaid insurance an accrual or deferral?
Any prepaid expenses are made in advance of receiving the goods or services. So, when you’re prepaying insurance, for example, it’s typically recognized on the balance sheet as a current asset and then the expense is deferred. The amount of the asset is typically adjusted monthly by the amount of the expense.
Why are accruals booked?
Accrual is an adjustment made to accounts to make sure revenue and expenses are properly matched. Regardless of whether cash has been paid or not, expenses incurred to generate revenue must be recorded.
What types of expenses are typically deferred?
Most commonly, expenses that are pre-paid are deferred, including insurance or rent. Other expenses that are deferred include supplies or equipment that are bought now but used over time, deposits, service contracts, or subscription-based services.
Intangible assets that are deferred due to amortization or tangible asset depreciation costs might also qualify as deferred expenses.