Definition
Accrual and deferral are two key finance terms used to describe different timing methods of accounting. Accrual refers to revenues or expenses that are recognized as they are earned or incurred, regardless of when the actual payment is received or made. On the other hand, deferral refers to revenues or expenses that are recognized only when the actual payment is made or received, even if the revenue was earned or expense incurred at an earlier time.
Key Takeaways
- Accrual aids in recording expenses and revenues as they occur, not when the cash is received or paid. This method gives a more accurate representation of a company’s financial health by reflecting income and expenditures in the correct accounting period.
- Deferrals refer to the business practice of postponing the recognition of income or expenditures until after the cash transaction has taken place. Deferred items are noted as either accrued assets (revenue) or accrued liabilities (expenses).
- Both accrual and deferral are critical accounting techniques used to ensure that financial statements comply with the matching principle, matching related revenues and expenses in the same accounting period to provide the most accurate financial picture. However, they do this in opposite ways, which affects the company’s cash flow statement and balance sheet.
Importance
The finance terms: accrual and deferral are important as they are both fundamental to the accrual method of accounting, which allows for better financial planning and analysis.
Accruals and deferrals are about timing and matching; they ensure that revenues and expenses are recorded in the correct periods.
Accrual essentially involves recording revenues when they are earned and expenses when they are incurred, irrespective of when the actual cash flow takes place.
Deferral, on the other hand, involves recording of prepayments for expenses to be incurred in the future or revenues received in advance of being earned.
This knowledge is crucial for stakeholders to assess a company’s financial health accurately since it provides a clearer picture by matching revenues with their corresponding expenses.
Explanation
Accrual and deferral are two key accounting concepts that deal with the timing of revenue and expense recognition, which play a vital role in smoothing away the discrepancies between cash movements and economic activities. Accrual is a principle that attempts to match revenues with the expenses incurred in earning them. It forms the basis of the accrual method of accounting and adjusting financial statements.
On the other hand, deferral serves the purpose of optimizing the accuracy of the company’s financial situation. Thus, companies use these practices to comply with the matching principle. In terms of the purpose and uses, the concepts of accrual and deferral are basically about the timing of when income and expenses are recorded.
Accrual assists in incorporating economic events regardless of when the actual cash transactions occur, providing a better understanding of a company’s real performance and financial position. Meanwhile, deferral is used to delay the recognition of certain financial transactions until an appropriate time, assisting in keeping financial statements logically consistent and accurately reflective of a business’s health. By using these two concepts, organizations can reflect a more accurate and precise picture of their financial performance.
Examples of Accrual vs Deferral
Subscription Services: Consider you have a Netflix subscription worth $120 that covers the entire year. In an accrual accounting approach, this will be recorded as an expense of $10 each month as the service is used, even though you have already paid the full amount upfront. On the other hand, in deferral accounting, the entire $120 would be treated as pre-paid and slowly $10 will be deducted from pre-paid expense account each month and moved to expenses.
Utility Bills: Utilities like electricity and water are typically considered on an accrual basis. Services are used throughout a month, but the bill doesn’t come until the next month. In accrual accounting, an estimate of the utility expense would be recorded in the month that the utility was actually used. On the contrary, no expense is recorded until the bill is paid in the deferral accounting or cash accounting method.
Insurance Policies: Suppose a company pays the yearly premium of $1200 for its insurance policy in January. If the company accounts this on an accrual basis, it will show a monthly expense of $100 (1200/12) on its income statement even though actual cash outflow happened at once in January. However, in deferral accounting, the $1200 outflow in January would be recorded as pre-paid insurance and each month $100 will be listed as an insurance expense reducing the balance of the pre-paid insurance account.
FAQ: Accrual vs Deferral
What is accrual in finance?
Accrual in finance is a method that recognizes revenues and expenses when they are incurred rather than when cash is exchanged. In other words, this method records incomes when earned and expenses when consumed, regardless of when the cash is actually received or paid.
What is deferral in finance?
Deferral in finance is the practice of recognizing a payment or receipt of cash in a period other than the one in which the cashflow occurs. This allows for an alignment of revenue and expense recognition. For instance, prepaid expenses are recognized in the period when the benefits are received, as opposed to when payment is made.
What is the difference between accrual and deferral in finance?
Accrual and deferral are two different concepts in financial accounting that deal with the timing of revenue and expense recognition. Accrual refers to the recording of revenues and expenses when they are earned or incurred, regardless of the actual cash exchange. On the other hand, deferral refers to the delay in recognition of revenues or expenses until the actual cash flow takes place.
What is the importance of understanding accrual and deferral in finance?
Understanding the principles of accrual and deferral is crucial in financial accounting as it allows for more accurate reporting of the financial position and performance of a company. It aids in aligning the revenues and expenses to the period they relate to, rather than when the cash is paid or received, providing a clearer picture of a company’s financial health.
Related Entrepreneurship Terms
- Accrual Accounting
- Deferred Expense
- Accrued Revenue
- Deferred Revenue
- Financial Statements
Sources for More Information
- Investopedia: A leading financial education platform with detailed explanations of a wide range of concepts, including accrual and deferral.
- Corporate Finance Institute (CFI): Offers a selection of informational guides, online courses and financial modeling programs.
- AccountingCoach: A resource offering free and premium accounting lessons, quizzes, and exercises.
- The Balance: Features a wealth of free resources on personal finance, career advancement, investing, and small business strategies.
