What Are Deferred Transactions in Accounting?

A deferred transaction in accrual basis accounting occurs when the timing of a cash payment or receipt differs from when the corresponding revenue or expense is recorded. The primary goal is to match revenues with the expenses incurred to generate them, a concept known as the matching principle. This approach provides a more accurate picture of a company’s financial health than simply tracking when cash changes hands.

Recognizing Deferred Revenue

Deferred revenue, also called unearned revenue, is recorded when a company receives payment from a customer for goods or services that have not yet been delivered or performed. This prepayment is treated as a liability on the company’s balance sheet because it represents an obligation to the customer. Common examples include a customer paying for a one-year software subscription upfront, the sale of gift cards, or a law firm receiving a retainer for future legal services.

Initially, when the cash is received, the company’s cash account is increased (a debit), and a liability account called “Deferred Revenue” or “Unearned Revenue” is created or increased (a credit). For instance, if a company receives $1,200 for an annual software subscription, the entry is a $1,200 debit to Cash and a $1,200 credit to Deferred Revenue.

As the company fulfills its obligation over time, it recognizes a portion of the deferred revenue as earned revenue. Following the $1,200 annual subscription example, the company would recognize $100 of revenue each month. This is recorded through an adjusting journal entry that decreases the Deferred Revenue liability account (a debit) and increases the Service Revenue account (a credit). This process continues each month until the full $1,200 has been moved from the liability account on the balance sheet to the revenue account on the income statement.

Accounting for Deferred Expenses

A deferred expense, often called a prepaid expense, occurs when a company pays for a good or service before it has been used or consumed. These prepayments are recorded as an asset on the balance sheet because they represent a future economic benefit to the company. For example, a business might pay for its entire year of liability insurance with a single upfront payment or prepay rent for its office space for the next six months.

When the initial payment is made, an asset account, such as “Prepaid Insurance” or “Prepaid Rent,” is increased (a debit), and the Cash account is decreased (a credit). If a business pays $12,000 for a one-year insurance policy, the journal entry would be a $12,000 debit to Prepaid Insurance and a $12,000 credit to Cash.

As the company consumes the benefit of the prepayment, the asset is gradually converted into an expense. In the case of the $12,000 insurance policy, the company would recognize $1,000 of insurance expense each month. This is done via an adjusting journal entry that increases the Insurance Expense account on the income statement (a debit) and decreases the Prepaid Insurance asset on the balance sheet (a credit). This process ensures that expenses are recorded in the same period as the benefits they help to generate.

Reporting on Financial Statements

Deferred revenue is presented on the balance sheet as a liability, typically classified as a current liability if the goods or services are expected to be delivered within one year. Conversely, deferred expenses (prepaid expenses) are shown on the balance sheet as an asset, usually a current asset, because they represent a resource that will be used in the near future.

The adjusting entries made over time to recognize these deferred items directly affect the income statement. As deferred revenue is earned, it is moved from the balance sheet liability to the income statement, increasing the company’s reported revenues. Similarly, as a prepaid expense is used, it is transferred from the balance sheet asset to the income statement, increasing the company’s reported expenses.