What Is the Main Difference Between Accrual and Deferral Adjustments?

Businesses use accounting adjustments to ensure their financial statements accurately reflect economic performance and financial position. These adjustments are necessary because the timing of cash receipts and payments often differs from when revenues are earned or expenses are incurred.

By making these adjustments, companies provide a more accurate view of profitability and financial health, moving beyond a simple record of cash movements. This process helps stakeholders understand a company’s obligations and resources at a specific point in time and over a given period.

Understanding Accrual Accounting

Businesses use two main accounting methods: cash basis and accrual basis. Cash basis accounting records revenues only when cash is received and expenses only when cash is paid out. It is simpler and often used by very small businesses or individuals. Conversely, accrual basis accounting recognizes revenues when they are earned and expenses when they are incurred, regardless of when cash changes hands. It is required for larger businesses and those that hold inventory, providing a more comprehensive view of financial performance.

Accrual accounting underpins the matching principle, a guideline that dictates expenses should be reported in the same period as the revenues they helped generate. For example, if a company makes a sale in December but receives payment in January, accrual accounting records the revenue in December. Similarly, if an employee earns wages in December but is paid in January, the expense is recognized in December. This principle ensures that financial statements are consistent and accurately reflect a business’s profitability for a given period.

Accrual Adjustments

Accrual adjustments involve recognizing revenues earned or expenses incurred, even though the cash exchange has not yet occurred. These adjustments are made when a transaction has occurred, creating a right to receive cash or an obligation to pay cash in the future. Their purpose is to align the recognition of revenues and expenses with the period in which they belong, adhering to the matching principle.

Accrued revenues represent income earned from providing goods or services before payment is received. For instance, a consulting firm that completes 50 hours of work for a client by month-end, but will only bill and receive payment the following month, would record that $2,000 (50 hours x $40/hour) as accrued revenue for the current month. Interest earned on a loan or investment not yet collected is another example. These amounts are recorded as assets, such as “Accounts Receivable” or “Accrued Interest Receivable,” reflecting future cash inflow.

Accrued expenses are costs a business has incurred but not yet paid. Employee salaries earned by month-end but not paid until the next payroll cycle are a common example. A utility bill for December’s electricity usage received in January would be accrued in December. These expenses are recorded as liabilities, such as “Salaries Payable” or “Utilities Payable,” indicating a future payment obligation.

Deferral Adjustments

Deferral adjustments involve recognizing revenues earned or expenses incurred after the related cash is exchanged. These adjustments are used when cash changes hands upfront, but the revenue is not yet fully earned or the expense not yet completely used up. The initial cash transaction creates either a liability (for unearned revenue) or an asset (for prepaid expenses), which is then adjusted over time as the revenue is earned or the expense is incurred.

Deferred revenues, also known as unearned revenues, occur when a company receives cash payment in advance for goods or services not yet delivered or performed. For example, a software company might receive $1,200 for a one-year subscription at the beginning of the year. Initially, this entire amount is recorded as a liability, “Unearned Revenue,” because the company still owes the service to the customer. As each month of the subscription passes, $100 ($1,200 / 12 months) of that unearned revenue is recognized as revenue on the income statement, reducing the liability.

Deferred expenses, often called prepaid expenses, are costs a company pays for in advance of receiving the benefit. A common illustration is a business paying $12,000 for a one-year insurance policy in January. The entire $12,000 is initially recorded as an asset, “Prepaid Insurance,” reflecting a future benefit. Each month, $1,000 ($12,000 / 12 months) of that prepaid insurance is recognized as an insurance expense, reducing the asset balance, matching the expense to the period of coverage.

Key Distinctions and Impact

The main distinction between accrual and deferral adjustments lies in the timing of the cash exchange relative to the recognition of the revenue or expense. With accruals, the revenue is earned or the expense is incurred before the cash is received or paid. For example, accrued interest income is earned before the cash is collected, and accrued salaries are incurred before employees are paid. This means an asset (right to receive cash) or a liability (obligation to pay cash) is recorded first.

Conversely, deferrals involve cash being received or paid before the revenue is earned or the expense is incurred. Deferred revenue is cash received for a service not yet provided, while deferred expenses are payments made for a benefit not yet consumed. In these cases, the initial cash transaction creates either a liability (unearned revenue) or an asset (prepaid expense) that is subsequently adjusted as the underlying activity occurs.