Understanding Deferrals in Accounting: Key Concepts and Examples

Introduction 

According to the accounting standards, public companies need to follow the accrual method of accounting. The method dictates that businesses should record transactions when goods and services are delivered rather than when cash is exchanged. In order to adhere to the accrual accounting principles, adjusting entries such as deferrals are pivotal. An understanding of how deferral expenses and revenues work is essential for organizations to comply with accounting standards and ensure accurate financial reporting. 

In this blog, we are going to discuss what are deferrals, how they work, and why deferral accounting is important for sound financial management. 

What Is a Deferral in Accounting? 

A deferral in accounting is used to recognize prepaid expenses or unearned revenue. A company will record a deferred expense when it has already paid for the goods or services, or a deferred revenue entry when it has received payment for the goods or services in advance. 

A deferred journal entry initially records the cash transaction but delays the recognition of the expense or revenue until the related goods or services are delivered or received. 

Deferrals are a type of adjusting entry and are important in order to adhere to the matching principle of accounting. These journal entries ensure that revenue and expenses are reflected on financial statements in the same accounting period as the delivery of goods and services. This helps businesses adhere to the accrual basis of accounting under which transactions should be recorded when revenue and expenses are earned and incurred rather than when cash is exchanged for goods. 

How do Deferrals Work?

Now that we know what deferrals are, let’s understand how they work. 

There are two types of deferred journal entries: deferred revenue and deferred expense. Let us understand them with some examples. . 

Deferred revenue

Deferred revenues are unearned revenues, meaning the company receives advanced payment for a service or good that they are yet to deliver to the customer. The initial payment made by the client is recorded as a liability on the balance sheet and is recognized as revenue over a period of time until the goods and services have been delivered. 

For instance, let’s suppose a client pays $12000 in advance to a company for their services that will be delivered every month at a price of $1000 for a year. 

The company will record the following journal entry when the initial payment is made: 

Date: January 1, 2024

Once the company starts delivering their services to the client, they will record the following journal entry after a month:

The company will record the same journal entry until the full services or goods are delivered to the client. 

Deferred expense

Deferred expenses are prepaid expenses, meaning the payment for a good or service is made in advance but the goods are yet to be received. Prepaid expenses are initially recorded on the balance sheet and expensed over time as the services are used. 

Let’s suppose a company makes a prepayment of $24,000 on January 1, 2024, to rent an office space for the year. They will record the following initial journal entry:

Date: January 1, 2024

The company will gain benefits from the asset after a month, and they will record the following adjusting journal entry on January 31, 2024:

The company will record the same adjusting journal entry till the entire benefit of the asset has been realized. 

Why to Use Deferrals in Accounting?

Deferrals are an important concept in accounting as they enable businesses to adhere to accounting standards and the accrual basis of accounting, ensuring financial accuracy, accountability, and integrity. 

Let’s understand closely why deferrals are beneficial to businesses and stakeholders:

1. Adherence to accrual accounting principles: As per the accrual accounting method, income should be recognized in the same time period as it earned and not when cash is exchanged. Similarly, expenses need to be matched with the revenue they help generate in the same accounting period according to the matching principle. Deferrals help businesses adhere to both the revenue recognition principle and the matching principle, thereby enabling them to follow the accrual accounting method. 
2. Accurate financial reporting: As deferrals help organizations follow the matching principle and the revenue recognition principle, the financial statements reflect the accurate financial position of a company. Without deferral entries, financial statements could be misleading, as there would be no way for external stakeholders to ascertain if the company has fulfilled its obligations of delivering goods and services to the customers. 
3. Regulatory compliance: Businesses need to use deferrals among other adjusting entries in order to adhere to accounting standards such as Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS). As per these standards, public companies need to follow the accrual accounting method to avoid legal penalties, and deferrals help businesses do the same. 
4. Enhanced cash flow management: Another key benefit of deferrals is that they enable businesses to distinguish between cash flow and profitability, giving a clearer picture of how the company is performing in terms of both. As the company knows its accurate financial position, it can manage its day-to-day operations better and make better financial decisions. 

Examples of Deferrals in Accounting

Deferred expenses include the cost of goods and service for which the company has already paid in advance, such as prepaid rent. Deferred revenue, on the other hand, is the unearned income that the company has generated through the sale of their goods or services, such as advance payment by a client for a service. 

Here are some of the common examples:

Deferrals vs. Accruals

Both deferrals and accruals are types of adjusting entries and are important accounting practices. They ensure financial integrity and accountability and adherence to accounting standards and principles. But despite their end goal of creating accurate financial statements, accruals and deferrals contrast starkly in nature. 

Here are the key differences between the two:

How to Manage Deferrals Using HighRadius’Record to Report Solution

The HighRadius Record to Report solution improves accounting by introducing automation to the forefront, dramatically increasing efficiency and accuracy. HighRadius’ no-code platform with an Excel-like interface, LiveCube, automates data extraction with customizable templates and is capable of handling millions of records. It enables enterprises to achieve 50% reduction in manual operations by automating processes such as data retrieval from multiple sources and grouping certain transactions to simplify journal entry posting. 

LiveCube allows users to do a one-time setup leveraging customizable templates for automating journal entry postings. Further, HighRadius’ Journal Entry Management facilitates auto-posting of entries of different formats to any ERP system or any other system of records, all the while ensuring compliance with industry standards. Journal entries can also be customized based on individual system records. Integrating this with LiveCube can enable manual preparation of journal entries using templates where all company data is auto-populated.

Journal Entry Management impacts the financial close process, allowing firms to achieve a 30% reduction in days to close. This function provides automated posting alternatives, which considerably speeds up the total closing process while maintaining accuracy. Close checklists and audit trail features provide a clear view of tasks that need to be completed and all the changes made to a task to maintain the integrity of the close process, ensuring audit and compliance readiness. The Maker Checker Workflow adds to the efficiency of the financial close process by segregating responsibilities and enabling the monitoring of priority tasks. 

HighRadius offers innovative solutions that can significantly streamline the process of creating and managing journal entries. With advanced automation, real-time data synchronization, and user-friendly interfaces, HighRadius helps businesses maintain accurate and efficient financial records. By leveraging HighRadius’ technology, businesses can enhance their financial processes, ensuring accurate and timely journal entries that support overall financial health.

FAQs

Q1. What are deferred expenses?

Deferred expenses are similar to prepaid expenses and are payments made in advance for services and goods for which the benefits will be realized in the future. For example, a company may make an advance yearly payment for their rented office space rather than paying every month.

Q2. Why would a business defer expenses or revenue?

A business defers expenses and revenue in order to adhere to accounting standards such as GAAP and IFRS. Moreover, businesses following the accrual accounting method need to use adjusting entries such as deferred expenses and deferred revenue to adhere to the matching principle. 

Q3. Is deferred revenue a credit or debit?

Deferred revenue is recorded as credit on the balance sheet. Deferred revenue is basically the revenue that the company has received in advance for the goods or services they are going to provide in the future. As the company needs to fulfill their obligations to the customer, deferred revenues are recorded under liabilities. 

Q4. What is an example of a deferred expense?

Deferred expenses are prepaid expenses, meaning the payments a company has already made for goods and services they are going to receive in the future. An example of a deferred expense would be an advance payment a company has made for software. Other examples include prepaid rent, prepaid insurance, and prepaid legal fees. 

Q5. Is a deferral an asset or a liability?

Deferred expenses and deferred revenue are recorded as assets and liabilities, respectively. Deferred revenue is the payment the company has already received for the services they will provide in the future, while deferred expenses are payments a company has made in advance for services they will get in the future. 

Q6. What are deferrals in accounting?

Deferrals in accounting are used to recognize prepaid expenses or unearned revenue. A company records a deferred expense when it has already paid for goods/services, or a deferred revenue entry when it has received payment for goods/services in advance. Deferrals are adjusting entries and help adhere to the matching principle.