Overview
In this article, we will cover the accrual vs deferral and its keys differences with example. Before, jumping into detail, let’s understand the overview and some key definitions.
The accounting system of a business follows the double-entry system of bookkeeping. This system of bookkeeping states that business transactions will be recorded in two different accounts in the accounting system of a business. This is because, according to the double-entry concept, a transaction affects, at least, two accounts. These transactions are first analyzed and then recorded in two corresponding accounts for the business transaction. These transactions are recorded using debit and a credit entry.
While the double entry system of bookkeeping is the main concept that dictates the rules of accounting, there are other concepts in accounting as well that are crucial in how business transactions are recognized, recorded or reported. These concepts include, but are not limited to, the separate entity concept, the going concern concept, consistency concept, etc. These accounting concepts are the base for the modern accounting system.
Two such concepts that are important in the accounting system of a business are the accruals and deferrals concepts. These concepts of accrual vs deferral are important concepts that play a vital role in the recognition of incomes and expenses of a business.
Definitions of Accrual and Deferral
The definitions of the terms accruals and deferrals are further breakdown into accrued revenue, accrued expense, deferred income and deferred expense as following:
Accruals
Accruals are incomes of a business that have been earned but have not yet been received, in form of compensation, by the business or expenses of the business that has been borne but not yet paid for. It is the basis for separate recognition of accrued expenses and accrued incomes in the financial statements of a business. The accruals concept of accounting requires businesses to record incomes or expenses when they have been earned or borne rather than when they are paid for.
Accrued Incomes or Accrued Revenue
Accrued incomes are the incomes of the business that it has already earned but has not yet received compensation for. For example, a business sells products to a customer but the customer has not yet paid for the products and the business has not yet billed the customer. These products can either be physical products such as manufactured goods or can also be the service. Similarly, another example is interest income that a business has rightfully earned but the interest is only credited to the bank account of the businesses semi-annually or annually. Accrued incomes are initially recorded as an asset of the business.
Accrued Expenses
On the other hand, accrued expenses are expenses of a business that the business has already consumed but the business is yet to pay for it. For example, utilities are already consumed by a business but the business only receives the bill in the next month after the utilities have been consumed. The business, therefore, makes the payment for the previous month’s expenses in the month after the expenses have been consumed. Hence, the business must record the expense in the month it is consumed rather than the month it pays for the expense. Accrued expenses are initially recognized as a liability in the books of the business.
Deferrals
Deferrals are the opposite of accruals. The deferrals are incomes that a business already receives cash for but has not yet earned or expenses that the company has already paid for but hasn’t yet consumed. We commonly call deferred expenses prepaid expenses. The deferral concept of accounting requires businesses to record the compensation received for the income or the compensation it pays for expenses but not record the related income or expenses until they have actually occurred. However, the deferral incomes are still recorded as a liability and the deferral expenses are recorded as assets of the business.
Deferred Incomes or Deferred Revenue
Deferred incomes are the incomes of a business that the customers of the business have already paid for but the business cannot recognize as income until the related product is provided to the customers. For example, some products, such as electronic equipment come with warranties or service contracts for 1 year. Since the business has not yet earned the amount they have charged for the warranty/service contract, it cannot recognize the amount received for the contract as an income until the time has passed. Usually, these types of incomes are recognized over time. The incomes are initially recognized as a liability for the business.
Deferred Expenses
Deferred expenses or prepaid expenses are expenses that the business has paid for but the business has not yet been compensated for. For example, sometimes businesses may be required to make advance payments for certain expenses, such as rent or insurance expenses. Until the business consumes the products or services that it has already paid for, it cannot recognize is as an expense. These expenses are initially recognized as an asset of the business.
Importance of Accrual vs Deferral
The main reason why accruals and deferrals are recorded in the books of a business as assets or liabilities instead of incomes or expenses is because of the matching concept. The matching concept of accounting states that incomes and expenses should be recognized in the period they relate to rather than the period in which a compensation is received or paid for them. This means this concept of accounting requires incomes and expenses to be recognized only when they have been earned or consumed rather than when the business receives or pays cash for them.
Similarly, accruals and deferrals are also recorded because the compensation for them has already been received or paid for. Therefore, one side of the double entry of the transaction is already recognized. However, since the matching concept will not allow them to be recognized as incomes or expenses, they must be recorded in the books of the business to complete the double entry. Therefore, these are recognized as assets and liabilities instead of incomes or expenses.
Likewise, in case of accruals, a business has already earned or consumed the incomes or expenses relatively. Therefore, they must be recognized and reported in the period that they have been earned or expensed to present a proper picture of the performance of the business. If these are not recognized in the period they relate to, the financial statements of the business will not reflect the proper performance of the business for that period. The proper representation of incomes and expenses in the periods they have been earned or consumed is also an objective of the matching concept of accounting.
Key Differences Between Accruals and Deferrals
The biggest difference between accruals vs deferrals is their recognition based on whether the business has already paid for the related income or expense or not and whether these incomes or expenses have been earned or consumed yet. When the product has already been delivered, i.e. business delivered the product or business consumed the product, but compensation was not received or paid for it, then it is considered as accrual. On the other hand, if a compensation was already received or paid for a product that was not delivered or consumed, then it is considered a deferral.
The other difference between the two is whether the income or expense is recognized as an asset or a liability. In case of accruals, incomes are recognized as an asset because a compensation receivable for them in the future while expenses are recognized as a liability because a compensation is payable for them in the future. However, for deferrals, incomes are recognized as a liability because the product will be delivered in the future but a compensation for them have already been received and expenses are recorded as an asset because the expenses have already been paid for but the related product has not yet been consumed by the business.
Example of Accruals and Accounting Treatment
A company ABC Co. receives a bill of $3,000 for electricity expenses for the previous month. However, the company has not yet paid for the expense. Because the electricity was already consumed by ABC Co., they must record the accrued expense in their books. The electricity expense will be recorded using double-entry accounting. Below is the journal entry for accrued expenses:
| Account Name | Debit US$ | Credit US$ |
|---|---|---|
| Electricity Expense | 3,000 | |
| Accrued Expenses (Liability) | 3,000 |
This accrual expense will appear as a short-term liability, or current liability, in the balance sheet of the company until the expense is paid for. The electricity expense of $3,000 will be a part of the income statement of the company for that period.
Once the expense is paid for, assuming by cash, the double entry will be as following:
| Account Name | Debit US$ | Credit US$ |
|---|---|---|
| Accrued Expenses (Liability) | 3,000 | |
| Cash | 3,000 |
Therefore, the accrual expense will be eliminated from the balance sheet of ABC Co for the next period. However, the electricity expense of $3,000 has already been recorded in the period and, therefore, will not be a part of the income statement of the company for the next period.
Similarly, the company provides repair services to a customer for $1,000 per month but only bills the customer once a quarter. Since the services are already rendered before the bill is sent, the company must record accrued income every month. This can be done using the following double entry to record the journal entry of accrued income:
| Account Name | Debit US$ | Credit US$ |
|---|---|---|
| Accrued Income | 1,000 | |
| Sales | 1,000 |
The accrued income is reported in the balance sheet of the company until paid for. The sales of $1,000 (per month) will also be reported in the income statement of ABC Co. for that period. Once the customer pays for the service, the accrued income is eliminated. The payment will be recorded using the following double entry:
| Account Name | Debit US$ | Credit US$ |
|---|---|---|
| Cash | 1,000 | |
| Accrued Income | 1,000 |
In the next period of reporting, the balance sheet of ABC Co. will not report the accrued income in the balance sheet as it has been eliminated. The income of $1,000 for the period will not be reported in the income statement for the next period as it has already been recognized and reported.
Example of Deferrals and Accounting Treatment
A company XYZ Co. pays its rents in advance for a year. The annual rent of the company is $12,000. Once the company pays the rent to the landlord, the company will record the payment as a deferred expense. The double entry will be as following to record the journal entry for deferred expenses:
| Account Name | Debit US$ | Credit US$ |
|---|---|---|
| Deferred expenses or Prepaid Expenses | 12,000 | |
| Cash | 12,000 |
The company will keep recognizing the rent expense of $1,000 ($12,000 / 12) every month. The double entry will be as following:
| Account Name | Debit US$ | Credit US$ |
|---|---|---|
| Rent Expense | 1,000 | |
| Deferred Expenses or Prepaid Expenses | 1,000 |
The deferred expense of XYZ Co. will be reported in its balance sheet until the 12 months pass. The rent expense will also be reported in the company’s income statement only for the months the rent relates to.
For example, if the company prepares its financial statements in the fourth month after the rent is paid in advance, the company will report a deferred expense of $8,000 ($12,000 – ($1,000 x 4)). Similarly, the rent expense in the income statement will be equal to $4,000 ($1,000 x 4) for only four months.
Similarly, the company also provides a warranty for its products for 12 months and receives $6,000 for the warranty period. When the sale is made, the warranty contract is recognized using the following double entry in order to record the journal entry of deferred income:
| Account Name | Debit US$ | Credit US$ |
|---|---|---|
| Cash | 6,000 | |
| Deferred Income | 6,000 |
The deferred income is gradually recognized as revenue as the months go by. To recognize the deferred income as revenue, the following double entry is passed every month:
| Account Name | Debit US$ | Credit US$ |
|---|---|---|
| Deferred Income ($6,000 / 12) | 5000 | |
| Revenue | 500 |
If the company prepares its financial statements in the fourth month after the warranty is sold to the customers, the company will report a deferred income of $4,000 ($6,000 – ($500 x 4)). Similarly, the company will report an income of $2,000 ($500 x 4) for the period.
Conclusion
Accrued incomes are incomes that have been delivered to the customer but for which compensation has not been received and customers have not been billed. Accrued expenses are expenses that have been consumed by a business but haven’t been paid for yet. Deferred incomes are incomes that the business has already received compensation for but have not yet delivered the related product to the customers. Deferred expenses are expenses for which the business has already paid for but have not consumed the related product yet. These are fundamental accounting concepts. These exist due to the matching concept in accounting.
