Each company has its own policies and procedures regarding the use of accruals and deferrals as part of their accounting process and these serve as the framework for its accountants when it comes to reporting.

What is an Accrual?

Accruals are adjustments made to a company’s accounting reports that involve the estimation of expenses or revenues that have not yet occurred but that have an impact in the company’s present performance or financial situation.

An example of an accrual would be the accrued salary expense of an employee for a given month, even though the payment hasn’t been made yet.

What is a Deferral?

Deferrals, on the other hand, are used to adjust the impact of present revenues and expenses throughout a comprehensive time period that reflects the true effect of the transaction on the company’s performance or financial situation.

An example of a deferral would be an annual insurance premium that is paid in full at the beginning of the year but the expenses is deferred on a monthly basis throughout the entire year.

Key Takeaways

Accrual vs Deferral – What’s the Difference?

When do they occur?

Accruals occur when a company has to recognize revenues or expenses that have not yet occurred in order to maintain the accuracy and relevancy of its financial reports. A company that has made a sale but hasn’t received the payment for it yet would accrue the revenue resulting from the transaction to incorporate the sale on the month that the invoice was issued, even though the payment is still pending.

In contrast, deferrals occur after the revenue or payment has occurred but the transaction is spread across other accounting periods to accurately reflect its impact on the company’s performance. The cost of purchasing machinery for a manufacturing company will be spread over several years through various depreciation charges applied on a monthly or annual basis to reflect the actual impact of this investment on the company’s performance instead of deducting the entire expense when it occurred.

When are they recorded?

Accruals are usually recorded once the company has acquired sufficient information to recognize the revenue or the expense. In most cases, accruals are based on factual evidence rather than plain estimations, nevertheless they could also result from a forecasted result as is the case for legal expenses associated to a lawsuit or a legal settlement. Even though the company may not know the actual expense associated to these proceedings, it may incorporate accrued expenses to increase the accuracy of its financial information.

Deferrals are recorded once the transaction takes place regardless of whether that is a revenue or an expense and the accounting department of the company, based on its policies, decides the length of the deferral and the amount that will be deferred. Then, usually through accounting systems, the accounting department can incorporate the expense at each deferred time period.

Finally, accruals and deferrals may result in the creation of an asset or a liability depending on their nature. An accrued revenue results in the creation of an asset while an accrued expense result in the creation of a liability. On the other hand, a deferred revenue results in the creation of a liability while a deferred expense generates an asset.

What are the purposes?

The purpose of both accruals and deferrals is to increase the accuracy of financial reports by incorporating elements that affect the performance or financial situation of the business. These adjustments provide more realistic figures that can be analyzed by managers and owners for decision-making purposes.

How do Accruals and Deferrals affect the Financial Statements?

Accruals and deferrals may have a significant effect on the main three financial statements.

Income Statement

Accrued and deferrals affect the income statement by increasing or decreasing specific revenues and expenses. Additionally, certain deferrals such as depreciation or amortization charges can affect a company’s financial performance for a given accounting cycle.

Balance Sheet

Since accruals and deferrals often generate an asset or liability, they also have an impact on the company’s financial situation as reflected on its Balance Sheet. Deferred or accrued assets are often listed as “other assets” or as part of the business’ current assets if they are expected to be fully amortized during the next 12 months.

Cash Flow Statement

Accruals and deferrals don’t have a direct impact on the company’s cash flow statement as this statements only recognizes cash revenues and expenses. In most cases, deferred expenses or revenues are adjusted through the Net Changes in Working Capital account or by adding back the deferred expense to the business Net Income as is the case for depreciation and amortization expenses.

Examples

Accrual Accounting Example

A construction company has won a contract to build a certain road for a municipal government and the project is expected to be concluded within 6 months. The company has received a $500,000 payment in advance that should cover 25% of the project’s cost and the accounting department has to make sure this transaction is treated appropriately.

As a result of this cash advance, a liability called “Projects Paid in Advance” was created and its current balance is $500,000. The company will issue a monthly invoice to the municipality to collect revenue according to project’s progress and once these revenues are generated the liability will be progressively diminished until the $500,000 balance is fully amortized This is an example of a deferred revenue.

Deferral Accounting Example

In contrast, the company has hired 2 project managers who will receive a wage and also a severance package once the project is completed. The cost of this severance package is estimated to be $65,000 in total and the company has created a liability called “Severance to be Paid”. Even though the payment hasn’t been made yet the company is anticipating it and incorporating its impact on its liabilities to increase the accuracy of its financial reports. This is an example of an accrued liability.

Bottom Line

Accruals and deferrals are accounting adjustments used to improve the accuracy and relevancy of financial reports. They function differently yet they share a similar purpose. Accountants and businesses use them on a regular basis and they are part of a company’s effort to provide accurate information to decision makers.

Frequently Asked Questions

What distinguishes accruals from deferrals in accounting practices?

Accruals involve recording income and expenses when they are earned or incurred, regardless of when cash is exchanged, while deferrals postpone the recognition of income or expenses until the cash is actually exchanged.

How do accruals impact financial statements compared to deferrals?

Accruals adjust the income statement for revenues earned and expenses incurred in the current period, affecting net income, whereas deferrals adjust the balance sheet by recognizing unearned revenue or prepaid expenses, impacting assets and liabilities.

Can you provide an example of an accrual and a deferral in accounting?

An example of an accrual is recording interest revenue before receiving the cash payment, while a deferral example is prepaying rent, which is recorded as a prepaid expense (asset) until the period it covers arrives.

Why are accruals and deferrals important for accurate financial reporting?

Accruals ensure that financial statements reflect all revenues earned and expenses incurred during a period, providing a true picture of a company’s financial performance, whereas deferrals ensure that revenues and expenses are matched with the period in which they are actually realized, maintaining the accuracy of financial statements over time.

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What Does Reporting Period Mean?

Reporting periods can be very different depending on the interested audience’s requirements. They refer to a given range of time that, after reaching its end, will produce a set of financial information about an organization such as a business, a non-profit or even a government agency. Reports are normally issued monthly or quarterly, depending on their nature and purpose. For internal uses, reports are often produced monthly, to inform shareholders or top executives about the company’s operations and financial status.

For external uses, these reporting periods are frequently extended to quarters or semesters and these are normally targeted to potential investors, government authorities or minor shareholders. In order to deliver the required information on schedule, most companies have automated administrative systems that can produce these reports within minutes. The most common financial reports issued are the balance sheet, the profit and loss statement and the cash flow statement. For annual reports, the volume of information reported is higher, since it covers many topics like marketing and sales information and financial forecasts.

Example

A company called Tropical Juices Co. produces bottled fruit juices that are sold in many retail establishments all around the country. It is a public company that trades in the New York Stock Exchange and since its foundation ten years ago it has grown exponentially, to reach $150,000,000 in annual sales.

Currently, the Board of Directors has different policies about financial reporting. The company’s senior management team must issue a comprehensive financial report each month that will be delivered to the Board of Directors exclusively, for decision-making purposes.

On the other hand, a quarterly report should be issued to the Board also, with more in-depth information about the business and its operations. Finally, legally required reports must be issued quarterly and annually and they must be disclosed to the public to comply with the listing rules of the stock exchange.

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What Does Suspense Account Mean?

From an accounting perspective, suspense accounts are used to reconcile the ledgers in the occasion that the nature of one or more transactions is unclear. For example, if a given deposit is received in the company’s bank account but there’s no record of a sale and the origin of the money is unknown the accountant can place this transaction in a suspense account until it can be properly classified.

Suspense accounts are commonly used when there is no paper trail for the transaction or the nature of it hasn’t been informed yet. Nevertheless, the size of these accounts should be fairly small since most transactions are easily categorized in a regular business operation. In the investment field, suspense accounts are also known as brokerages accounts set for short-term periods until the money is allocated in a client’s account; this is the case when a client is opening an account but its unique account number hasn’t been assigned yet.

Example

Mr. Gladwell is the owner of a small bakery located in the suburbs. Each week he purchases some of the materials needed to manufacture the bakery’s products and he pays for them with the company’s debit card. Last week he purchased a new refrigerator for $300 but due to his busy schedule he failed to send the receipt of the transaction to his accountant.

At the end of the month, his accountant had to reconcile the bakery’s ledgers but there was a bank transaction of $300 that he had no record off. In order to file the monthly tax report on time he put this amount in a suspense account and the ledgers were reconciled perfectly.

After that, he consulted with Mr. Gladwell who clarified the nature of the operation. His accountant then reclassified the operation as a fixed asset purchase and the suspense account balance was removed.

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What Does End of Year (EOY) Mean?

In business, the EOY can be defined as the end of the calendar year or the fiscal year. The calendar year is the twelve month period that starts on January 1 and ends on December 31. In this case, the EOY will be December 31.

On the other hand, a fiscal year is a twelve-month period defined for accounting purposes. This period might be different from the calendar year, which means that it might start on a day different than January 1.

This one-year accounting period is established to suit a particular need of the company, since sometimes issuing a financial statement at the end of the calendar year is a though task because of the high volume of transactions going on at the time. This difference between a calendar year and a fiscal year is normally recognized by tax authorities and companies are normally free to declare and pay taxes at the end of their fiscal (not calendar) year.

Example

For example, Big Bikes LLC is a company that sells imported bikes to retail customers in 4 different states of the U.S. through a chain of 20 stores located in highly-populated areas. The company is currently reviewing its accounting procedures and policies and the company’s Head Accountant advised the owners to change its fiscal year.

They were currently working with a fiscal year equal to the calendar year but the Head Accountant pointed out that this was affecting financial procedures negatively since the company experienced a sales peak between January and March because many people started buying new bikes to exercise after Christmas.

The fact that the fiscal year ended in December meant that the accounting team had to work on the financial statements between January and March, and they also had to handle the bookkeeping and reporting duties of a high-sales season. He pointed out it was a nightmare for the team.

After reviewing the matter the owners decided to change the fiscal year to start on April 1 and end on March 31.

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What Does Bank Draft Mean?

This kind of check is usually employed when the amount of money being paid is large, or when the two parties do not know each other that well. Therefore, a secure form of payment is required to complete the transaction. Drafts are also used when one of the parties does not accept personal checks in doubt that the funds may not actually be available.

A bank issues a bank draft when one of its depositors (a person who holds an account in such bank) requests one using the following steps. First, the bank checks to depositor’s account to make sure the funds are available for transfer. After the funds have been validated, the bank transfers the money from the depositor’s account to the bank. This is what makes these drafts more reliable than other forms of payments; as the bank already has the money that will be paid and the document is backed by a reputed financial institution. The draft is then issued and handed to the client who will afterwards deliver it to the seller or recipient.

These drafts are commonly used as method of payment for real estate transactions or used vehicle purchases.

Let’s look at an example.

Example

Octavio is looking to purchase a used car for his son, as he recently turned 18 years old. He negotiated with Mr. Thompson to buy his 2014 Hyundai Accord. Since Mr. Thompson doesn’t know Mr. Octavio, he doesn’t want to take a risk that Mr. Octavio’s personal check not clear, so he requires Mr. Octavio to pay with a bank check. In order to settle the transaction, Mr. Octavio asked his bank to issue a bank draft for $8,000 to pay Mr. Thompson.

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