What Are Accruals and Deferrals in Accounting?

Most businesses operate under the accrual basis of accounting, which recognizes revenues when earned and expenses when incurred, regardless of when cash is received or paid. Accruals and deferrals are adjustments made to financial records to align with this principle. These adjustments ensure that a company’s financial statements accurately reflect its economic performance and position over a specific period.

Understanding Accruals

Accruals represent revenues a business has earned but not yet received cash for, or expenses it has incurred but not yet paid. These transactions are recognized in the financial records before any cash exchange occurs. The purpose of accruals is to ensure that revenues are matched with the expenses that helped generate them within the correct accounting period. This alignment provides a more precise picture of a company’s profitability.

Accrued revenues, also known as accrued income, occur when a business earns revenue by providing goods or services, but the customer has not yet paid. For example, a consulting firm might complete a project for a client in December but not bill them until January. This entry increases revenue on the income statement and creates an asset, typically Accounts Receivable, on the balance sheet.

Accrued expenses, or accrued liabilities, represent expenses a business has incurred but not yet paid. A common example is employee salaries and wages; employees earn their pay throughout a period, but the company might only issue paychecks bi-weekly. If the accounting period ends before payday, the company records the wages earned as an accrued expense. This increases the expense on the income statement and creates a liability, such as Accrued Wages Payable, on the balance sheet.

These adjustments are recorded as adjusting entries at the end of an accounting period, such as monthly, quarterly, or annually. They ensure that the financial statements accurately reflect the economic activity of the period.

Understanding Deferrals

Deferrals involve transactions where cash changes hands before the revenue is earned or the expense is incurred. These adjustments ensure that revenues and expenses are recognized in the period they are genuinely earned or consumed, not just when the cash is received or paid.

Deferred revenues, also called unearned revenue, occur when a business receives cash for goods or services it has not yet delivered. A common example is a software company receiving an annual subscription payment upfront. At the time of receipt, the company has an obligation to provide service over the next year. Initially, receiving this cash increases the company’s cash balance but also creates a liability on the balance sheet, reflecting the obligation to the customer.

Over time, as the software company provides its service each month, a portion of the unearned revenue is recognized as actual revenue. This adjustment reduces the liability on the balance sheet and increases the revenue reported on the income statement for that period. This systematic recognition ensures that revenue is matched to the period in which the service is rendered.

Deferred expenses, also known as prepaid expenses, arise when a business pays cash for an expense to be consumed or incurred in a future period. For instance, a company might pay a six-month insurance premium in advance. At the time of payment, the company has not yet used the insurance coverage for the entire period. This initial payment decreases cash but creates an asset on the balance sheet, representing the future economic benefit of the prepaid service.

As each month passes and the insurance coverage is utilized, a portion of the prepaid expense is recognized as an actual expense. This adjustment reduces the asset balance on the balance sheet and increases the insurance expense on the income statement. This method ensures that the expense is recognized in the period the benefit is received.

The Importance of Accruals and Deferrals

Accruals and deferrals are important for presenting an accurate financial picture of a business. These adjustments ensure the income statement reflects a company’s profitability by correctly matching revenues to the expenses incurred. The balance sheet also provides a precise snapshot of a company’s assets and liabilities. Without these adjustments, financial statements would only show cash movements, which can be misleading regarding actual performance and financial health.

These adjustments are required by generally accepted accounting principles (GAAP) in the United States and International Financial Reporting Standards (IFRS) globally. Adherence to these principles is a requirement for external financial reporting, ensuring comparability and reliability of financial information. Companies preparing financial statements for investors, creditors, or regulatory bodies must comply with these guidelines.

Accurate financial statements, made possible by accruals and deferrals, provide stakeholders with reliable information for informed decision-making. Investors rely on these statements to assess a company’s past performance and future potential. Creditors use this information to evaluate a company’s ability to repay loans. Management teams also leverage these financial insights to make operational and strategic decisions, such as budgeting, pricing, and resource allocation.

Accruals and deferrals directly support the accounting principles of revenue recognition and the matching principle. Revenue recognition dictates that revenue should be recognized when earned, regardless of when cash is received. The matching principle requires that expenses be recognized in the same period as the revenues they helped generate. These adjustments ensure a company’s financial records accurately reflect its economic activities.