What Is the Main Difference Between Accrual and Deferral Adjustments?
Understand how crucial accounting adjustments correctly reflect business finances, aligning revenue and expenses with their true economic timing.
Adjusting entries are essential in financial accounting, refining a company’s financial records at the close of an accounting period. These adjustments ensure financial statements accurately portray an organization’s financial position and performance. The process aligns with the accrual basis of accounting and the matching principle, which are core tenets of Generally Accepted Accounting Principles (GAAP). By making these entries, businesses recognize economic events when they occur, rather than solely when cash changes hands. This approach provides a more comprehensive view of a company’s financial health, allowing for better-informed decision-making.
Understanding Accruals
Accruals represent revenues earned or expenses incurred for which the cash has not yet been received or paid. This means the economic activity has taken place, but the corresponding cash transaction will happen at a later date. Accruals ensure that financial statements reflect all economic events of a period.
One type is accrued revenues, which are revenues a business has earned by providing goods or services but for which it has not yet collected payment. An example includes a consulting firm completing a project for a client in December, but the client will pay in January. The revenue is recognized in December, when the service was rendered, even though the cash receipt is delayed. This creates an asset, typically an accounts receivable, on the balance sheet.
Another type is accrued expenses, which are expenses a business has incurred but has not yet paid. For instance, a company might use utilities throughout December but receive the bill and pay for it in January. The utility expense is recognized in December, reflecting the period the service was consumed, and a liability, such as utilities payable, is recorded.
Understanding Deferrals
Deferrals represent cash that has been received or paid for which the revenue has not yet been earned or the expense has not yet been incurred. In these situations, the cash transaction occurs first, and the economic event follows over time.
Unearned revenues are a type of deferral where a business receives cash from a customer before providing the goods or services. For example, a software company might receive an annual subscription payment upfront from a customer. Initially, this cash inflow is recorded as a liability, representing the obligation to provide future services. As the company delivers the service over the subscription period, a portion of the unearned revenue is recognized as earned revenue.
Prepaid expenses are the other type of deferral, occurring when a business pays cash for an expense that will benefit future accounting periods. An insurance premium paid for the next 12 months is a common example. The initial cash payment creates an asset, prepaid insurance, on the balance sheet. As each month passes, a portion of the prepaid asset is recognized as an expense, reflecting the consumption of the insurance coverage.
Key Distinctions and Illustrative Examples
The main distinction between accruals and deferrals lies in the timing of the cash exchange relative to the economic event. Accruals involve recognizing a revenue or expense before the cash changes hands. The economic activity, such as providing a service or incurring a cost, comes first, and the cash flow follows.
In contrast, deferrals involve the cash changing hands before the revenue is earned or the expense is incurred. The cash transaction precedes the economic event. This means a company either receives cash for services yet to be performed or pays cash for benefits yet to be consumed.
Consider a business that provides landscaping services. If the business completes a landscaping project in June but invoices the client for payment in July, this is an accrual. The revenue is recognized in June when the work is done, creating an accounts receivable. Conversely, if a client pays the landscaping business in May for services to be performed in July, this is a deferral. The cash is received in May, but it is recorded as unearned revenue until the services are provided in July.