Accruals and Deferrals in Accounting
Accruals and deferrals are both concepts used in accounting to adjust the
timing of recognizing revenue and expenses, ensuring that financial
statements accurately reflect a company's financial position and
performance.
1. Accruals:
Accrual accounting requires that revenues and expenses are recorded
when they are earned or incurred, not when cash is actually received or
paid. This allows a company to recognize revenue and expenses in the period
they occur, giving a more accurate picture of financial performance.
Accrued Revenue: This is revenue that has been earned but has not
yet been billed or collected.
Accrued Expense: This is an expense that has been incurred but not
yet paid.
Examples of Accruals:
a) Accrued Revenue (Revenue earned but not yet received): Suppose
a company provides services to a client in December but doesn't receive
payment until January. The revenue for December should be recognized in
December, as the service was performed that month.
Example Journal Entry (Accrued Revenue):
Dr. Accounts Receivable $5,000 (asset account, the company
expects to receive this amount)
Cr. Service Revenue $5,000 (recognizing the revenue earned in
December)
b) Accrued Expense (Expense incurred but not yet paid): If an
employee works in December but isn't paid until January, the company needs
to recognize the wage expense in December, even though the payment will
be made in January.
Example Journal Entry (Accrued Expense):
Dr. Wage Expense $1,000 (recognizing the expense for December)
Cr. Accrued Liabilities (or Wages Payable) $1,000 (recording the
amount owed)
2. Deferrals:
Deferrals are the opposite of accruals. They refer to situations where cash is
received or paid before the revenue or expense is recognized. The
revenue or expense is "deferred" to a future period.
Deferred Revenue (Unearned Revenue): This is money received
for goods or services that have not yet been delivered or performed.
Deferred Expense (Prepaid Expense): This is a payment made in
advance for goods or services that will be used in the future.
Examples of Deferrals:
a) Deferred Revenue (Cash received before earning revenue): If a
company receives payment in advance for a service or product that will be
provided over the next few months, it cannot recognize the entire payment
as revenue immediately. Instead, it defers the revenue recognition until the
service is provided or the goods are delivered.
Example Journal Entry (Deferred Revenue):
Dr. Cash $2,000 (payment received in advance)
Cr. Deferred Revenue (Liability) $2,000 (liability, as the service or
goods have not yet been delivered)
As the service is provided over time, the company will recognize the revenue
by transferring it from deferred revenue to earned revenue:
Dr. Deferred Revenue $500 (reducing liability)
Cr. Service Revenue $500 (recognizing earned revenue)
b) Deferred Expense (Cash paid before expense incurred): If a
company pays for insurance in advance (say, $1,200 for a one-year policy),
the company will record the expense over the year, not all at once, because
the expense is incurred over time.
Example Journal Entry (Deferred Expense): When the company pays for
insurance:
Dr. Prepaid Insurance $1,200 (asset account, the amount paid in
advance)
At the end of each month (assuming the insurance covers a year), the
company will recognize a portion of the expense:
Dr. Insurance Expense $100 (recognizing the expense for one
month)
Cr. Prepaid Insurance $100 (reducing the prepaid asset)
Summary:
Accruals recognize revenues or expenses before cash is received or
paid:
o Accrued Revenue: Earned but not yet received.
o Accrued Expense: Incurred but not yet paid.
Deferrals recognize revenues or expenses after cash is received or
paid:
o Deferred Revenue (Unearned Revenue): Cash received in
advance of earning the revenue.
o Deferred Expense (Prepaid Expense): Payment made in
advance for goods or services to be used in the future.
