What is a Deferral?
A Deferral refers to revenue that was received before delivery of the product or service to the customer, as well as expenses paid in advance.
The recognition of a deferral results when a customer paid for a product or service in advance, or when a company made a payment to a supplier or vendor for a benefit expected to be received in the future.
Deferral Adjusting Entries in Accrual Accounting
Deferrals are adjusting entries in a company’s general ledger for revenue generated before the actual delivery of the product or service to the customer, and expenses paid for and expensed prior to the actual completion of the transaction.
Under accrual accounting, the use of deferrals enables companies to reflect revenue or expense line items that will later appear on the financial statements during the appropriate period in which the product or service is actually delivered.
Deferrals are adjusting entries that delay the recognition of financial transactions and push them back to a future period.
The importance of deferral adjustments stems from two accrual accounting principles:
- Revenue Recognition Principle → Revenue is recognized in the period it was “earned” – i.e. when the product or service is delivered to the customers – rather than when the cash payment is received.
- Matching Principle → Expenses should be recognized in the same period as when the corresponding revenue benefit was received, i.e. the revenue and associated expense are matched and recorded in the same period.
Accrual vs. Deferral – Differences
The recognition of accrual and deferral accounts are two core concepts in accrual accounting that are both related to timing discrepancies between cash flow basis accounting and accrual accounting.
Like accruals, deferrals also have a critical role in ensuring financial statement reporting is kept accurate, consistent, and transparent for investors.
In short, there is no receipt of cash payment for an accrual, whereas there is a payment of cash made in advance for a deferral.
The difference between the accruals and deferrals is namely the timing around receiving cash.
- Accrual → An example of an accrual would be revenue recognized before receipt of the cash payment, i.e. accounts receivable.
- Deferral → An example of a deferral would be payment received before the revenue is earned, such as a company receiving cash from a customer before fulfilling their obligation to provide the product or service, i.e. deferred revenue.
Deferral Example – Deferred Revenue
A revenue deferral is an adjusting entry intended to delay a company’s revenue recognition to a future accounting period once the criteria for recorded revenue have been met.
Suppose a company decided to receive a payment in advance for a year-long subscription service.
Each month, 1/12th of the total year-long revenue for the service will be recognized once the customer receives the benefit.
The cash received before the revenue is earned per accrual accounting standards will thus be recorded as deferred revenue.
The “Deferred Revenue” line item depicts the unearned revenue that will be reported in a later period.
The reason for pushing back the recognition date is that the company has received payment from the customer(s) before delivering the purchased goods or services, so it cannot appear on the financial statements until the goods / services are delivered.
Deferral Example – Prepaid Expense
An expense deferral is an adjusting entry meant to push the recognition of an expense to a later date, which is done because payment has been issued for a product or service before the recognition of the associated revenue.
An example of a deferral would be a company paying for rent in advance. In order to abide by the matching principle, a deferral must be made to adjust for the prepaid rent expense.
On the company’s balance sheet, the rent would be captured in the “Prepaid Expense” line item, typically categorized as a current asset, since all that remains is the tax benefits when the expenses are actually recognized on the income statement (i.e. the rent has already been paid for, now only benefits are left).
From the perspective of the landowner, the rent cannot be recognized as revenue until the company has received the benefit, i.e. the month spent in the rented building.
To summarize, deferrals move the recognition of a transaction to a future period, while accruals record future transactions in the current period.