Accrual and deferral are two accounting techniques that intend to improve the accuracy of financial reports by incorporating revenues and expenses that have not yet occurred or that will occur in the near future. Their main goal is to increase the precision of financial reports by providing a more realistic picture of the organization’s financial situation.
Each company has its own policies and procedures regarding the use of accruals and deferrals as part of their accounting process and these serve as the framework for its accountants when it comes to reporting.
What is an Accrual?
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Accruals are adjustments made to a company’s accounting reports that involve the estimation of expenses or revenues that have not yet occurred but that have an impact in the company’s present performance or financial situation.
An example of an accrual would be the accrued salary expense of an employee for a given month, even though the payment hasn’t been made yet.
What is a Deferral?
Deferrals, on the other hand, are used to adjust the impact of present revenues and expenses throughout a comprehensive time period that reflects the true effect of the transaction on the company’s performance or financial situation.
An example of a deferral would be an annual insurance premium that is paid in full at the beginning of the year but the expenses is deferred on a monthly basis throughout the entire year.
Key Takeaways
Timing Differences: Accruals recognize revenues and expenses when they are earned or incurred, regardless of cash flow, highlighting the economic activity of a period, whereas deferrals delay recognition until cash is exchanged, aligning accounting records with cash transactions.
Impact on Financial Statements: Accruals adjust the income statement by recognizing earned revenue and incurred expenses in the current period, affecting net income, while deferrals primarily affect the balance sheet through adjustments to assets and liabilities until the revenue is earned or the expense is incurred in a future period.
Matching Principle Adherence: Both accruals and deferrals are essential for adhering to the matching principle in accounting, ensuring that revenues and expenses are recorded in the period they are earned or incurred, which provides a more accurate and meaningful financial performance and position of a company.
Accrual vs Deferral – What’s the Difference?
When do they occur?
Accruals occur when a company has to recognize revenues or expenses that have not yet occurred in order to maintain the accuracy and relevancy of its financial reports. A company that has made a sale but hasn’t received the payment for it yet would accrue the revenue resulting from the transaction to incorporate the sale on the month that the invoice was issued, even though the payment is still pending.
In contrast, deferrals occur after the revenue or payment has occurred but the transaction is spread across other accounting periods to accurately reflect its impact on the company’s performance. The cost of purchasing machinery for a manufacturing company will be spread over several years through various depreciation charges applied on a monthly or annual basis to reflect the actual impact of this investment on the company’s performance instead of deducting the entire expense when it occurred.
When are they recorded?
Accruals are usually recorded once the company has acquired sufficient information to recognize the revenue or the expense. In most cases, accruals are based on factual evidence rather than plain estimations, nevertheless they could also result from a forecasted result as is the case for legal expenses associated to a lawsuit or a legal settlement. Even though the company may not know the actual expense associated to these proceedings, it may incorporate accrued expenses to increase the accuracy of its financial information.
Deferrals are recorded once the transaction takes place regardless of whether that is a revenue or an expense and the accounting department of the company, based on its policies, decides the length of the deferral and the amount that will be deferred. Then, usually through accounting systems, the accounting department can incorporate the expense at each deferred time period.
Finally, accruals and deferrals may result in the creation of an asset or a liability depending on their nature. An accrued revenue results in the creation of an asset while an accrued expense result in the creation of a liability. On the other hand, a deferred revenue results in the creation of a liability while a deferred expense generates an asset.
What are the purposes?
The purpose of both accruals and deferrals is to increase the accuracy of financial reports by incorporating elements that affect the performance or financial situation of the business. These adjustments provide more realistic figures that can be analyzed by managers and owners for decision-making purposes.
How do Accruals and Deferrals affect the Financial Statements?
Accruals and deferrals may have a significant effect on the main three financial statements.
Income Statement
Accrued and deferrals affect the income statement by increasing or decreasing specific revenues and expenses. Additionally, certain deferrals such as depreciation or amortization charges can affect a company’s financial performance for a given accounting cycle.
Balance Sheet
Since accruals and deferrals often generate an asset or liability, they also have an impact on the company’s financial situation as reflected on its Balance Sheet. Deferred or accrued assets are often listed as “other assets” or as part of the business’ current assets if they are expected to be fully amortized during the next 12 months.
Cash Flow Statement
Accruals and deferrals don’t have a direct impact on the company’s cash flow statement as this statements only recognizes cash revenues and expenses. In most cases, deferred expenses or revenues are adjusted through the Net Changes in Working Capital account or by adding back the deferred expense to the business Net Income as is the case for depreciation and amortization expenses.
Examples
Accrual Accounting Example
A construction company has won a contract to build a certain road for a municipal government and the project is expected to be concluded within 6 months. The company has received a $500,000 payment in advance that should cover 25% of the project’s cost and the accounting department has to make sure this transaction is treated appropriately.
As a result of this cash advance, a liability called “Projects Paid in Advance” was created and its current balance is $500,000. The company will issue a monthly invoice to the municipality to collect revenue according to project’s progress and once these revenues are generated the liability will be progressively diminished until the $500,000 balance is fully amortized This is an example of a deferred revenue.
Deferral Accounting Example
In contrast, the company has hired 2 project managers who will receive a wage and also a severance package once the project is completed. The cost of this severance package is estimated to be $65,000 in total and the company has created a liability called “Severance to be Paid”. Even though the payment hasn’t been made yet the company is anticipating it and incorporating its impact on its liabilities to increase the accuracy of its financial reports. This is an example of an accrued liability.
Bottom Line
Accruals and deferrals are accounting adjustments used to improve the accuracy and relevancy of financial reports. They function differently yet they share a similar purpose. Accountants and businesses use them on a regular basis and they are part of a company’s effort to provide accurate information to decision makers.
Frequently Asked Questions
What distinguishes accruals from deferrals in accounting practices?
Accruals involve recording income and expenses when they are earned or incurred, regardless of when cash is exchanged, while deferrals postpone the recognition of income or expenses until the cash is actually exchanged.
How do accruals impact financial statements compared to deferrals?
Accruals adjust the income statement for revenues earned and expenses incurred in the current period, affecting net income, whereas deferrals adjust the balance sheet by recognizing unearned revenue or prepaid expenses, impacting assets and liabilities.
Can you provide an example of an accrual and a deferral in accounting?
An example of an accrual is recording interest revenue before receiving the cash payment, while a deferral example is prepaying rent, which is recorded as a prepaid expense (asset) until the period it covers arrives.
Why are accruals and deferrals important for accurate financial reporting?
Accruals ensure that financial statements reflect all revenues earned and expenses incurred during a period, providing a true picture of a company’s financial performance, whereas deferrals ensure that revenues and expenses are matched with the period in which they are actually realized, maintaining the accuracy of financial statements over time.
