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Difference Between Accrual vs Deferral
Accrual accounting and deferral are fundamental concepts in the field of accounting, shaping how businesses recognize and record financial transactions. These methods play a crucial role in providing a comprehensive and accurate representation of a company’s financial position over time. In this context, accrual accounting involves recognizing revenues and expenses when they are earned or incurred, regardless of the actual cash flow. On the other hand, deferral accounting involves postponing the recognition of certain revenues or expenses until a later accounting period, often aligning with the timing of cash transactions.
Understanding the Difference between accrual and deferral is essential for businesses to present financial statements that truly reflect their economic activities. This introduction sets the stage for exploring the key differences, implications, and applications of accrual accounting and deferral in the realm of financial management.
What is Accrual?
In accounting, an accrual refers to the recognition of revenue or expenses before the corresponding cash transaction takes place. Accruals are adjustments made to financial statements to ensure that they accurately reflect the economic activities of a business during a specific time period. This is in contrast to cash accounting, where transactions are recorded only when cash changes hands.
Example of Accrual:
Let’s consider a scenario where a company provides consulting services to a client in December but does not receive payment until January of the following year.
- Accrual Accounting:
- In December, the company recognizes the revenue for the consulting services even though it has not yet received payment. The entry would be:
Account Debit (+) Credit (-) Accounts Receivable (Asset) $5,000 Consulting Revenue (Revenue) $5,000 This entry indicates that the company has earned $5,000 in revenue for the services provided, and it expects to receive payment in the future.
- In December, the company recognizes the revenue for the consulting services even though it has not yet received payment. The entry would be:
- Cash Accounting:
- In December, under cash accounting, no entry would be made because cash has not been received. The revenue would only be recognized in January when the payment is received.
The accrual accounting method provides a more accurate representation of the company’s financial performance during the period when the services were actually rendered, even if the cash transaction occurs later. Accruals help align revenue and expenses with the periods in which they are incurred or earned, providing a better reflection of the company’s financial position.
What is Deferral?
In accounting, a deferral refers to the postponement of recognizing certain revenues or expenses until a later accounting period. This is done to match the recognition of these items with the period in which they are earned or incurred, aligning with the matching principle in accrual accounting. Deferral involves adjusting entries to ensure that financial statements accurately reflect the economic reality of a business.
There are two main types of deferrals:
1. Deferred Revenue (or Unearned Revenue):
Deferred revenue occurs when a company receives payment for goods or services before they are delivered or rendered.
Example: Imagine a company that receives an advance payment for an annual subscription in December but will deliver the services evenly over the next 12 months. In December:
Account | Debit (+) | Credit (-) |
---|---|---|
Cash (Asset) | $1,200 | |
Deferred Revenue (Liability) | $12,00 |
This entry reflects the increase in cash and the corresponding liability for unearned revenue. As services are provided each month, a portion of the deferred revenue will be recognized as revenue.
2. Deferred Expense (Prepaid Expense):
Deferred expense occurs when a company pays for goods or services in advance but has not yet incurred the related costs.
Example: Consider a business that pays $600 for insurance coverage for the next six months in December. In December:
Account | Debit (+) | Credit (-) |
---|---|---|
Prepaid Insurance (Asset) | $600 | |
Cash (Asset) | $600 |
This entry reflects the increase in the prepaid insurance asset and the corresponding decrease in cash. Over the next six months, a portion of the prepaid insurance will be expensed each month.
Accrual vs. Deferral
Aspect | Accrual Accounting | Deferral Accounting |
---|---|---|
Definition | Recognizes revenue/expenses when incurred | Postpones recognition until a future accounting period |
Timing of Recognition | Before cash changes hands | After cash changes hands |
Example – Revenue | Recognizes revenue when earned | Postpones recognition until services are provided |
Example – Expense | Recognizes expenses when incurred | Postpones recognition until benefits are realized |
Entry – Revenue | Dr. Accounts Receivable / Cr. Revenue | Dr. Cash / Cr. Deferred Revenue |
Entry – Expense | Dr. Expense / Cr. Accounts Payable | Dr. Prepaid Expense / Cr. Cash |
Purpose | Reflects economic events as they occur | Aligns recognition with when benefits are realized |
Matching Principle | Follows the matching principle | Delays recognition until related events occur |
Accrual Accounting: Recognizes revenue and expenses when incurred, irrespective of cash flow timing. Follows the matching principle to provide a real-time view of a company’s financial position.
Deferral Accounting: Postpones recognition of revenue or expenses until a future accounting period, aligning with the timing of cash transactions. Delays recognition until related events, like service provision or benefits realization, occur.
Accrual vs. Deferral – Key Difference
Here’s a key difference between Accrual and Deferral presented
Accrual Accounting:
- Recognizes revenue and expenses when they are incurred, regardless of cash flow timing.
- Revenue is recognized when earned, and expenses are recognized when incurred.
- Example: Services provided in December result in revenue recognition in December.
Deferral Accounting:
- Postpones recognition of revenue or expenses until a future accounting period, depending on cash flow timing.
- Revenue is recognized when cash is received, and expenses are recognized when cash is paid.
- Example: Services prepaid in December lead to revenue recognition when services are provided.