What Is a Deferral? It’s Expenses Prepaid or Revenue Not yet Earned
A deferral accounts for expenses that have been prepaid, or early receipt of revenues. In other words, it is payment made or payment received for products or services not yet provided. Deferrals allows the expense or revenue to be later reflected on the financial statements in the same time period the product or service was delivered.
Here’s What We’ll Cover:
What Is a Deferral in Accounting?
A deferral refers to money paid or received before a product or service has been provided. Here are some examples of deferrals:
- Insurance premiums
- Subscription based services (newspapers, magazines, television programming, etc.)
- Prepaid rent
- Deposits on products
- Service contracts (example: cleaners)
- Tickets for sporting events
What Is the Difference Between an Accrual and a Deferral?
Accruals and Deferrals are both broken down into expenses and revenue:
Accrued expenses are expenses a company needs to account for, but for which no invoices have been received and no payments have been made. Accrued expenses would be recorded under the section “Liabilities” on a company’s balance sheet.
Accrued revenue are amounts owed to a company for which it has not yet created invoices for. They are recorded as “Assets” on a balance sheet.
Deferred expenses are expenses a company has prepaid. They are recorded as “Assets” on a balance sheet.
Deferred revenue is income a company has received for its products or services, but has not yet invoiced for. They are considered “Liabilities” on a balance sheet.
The easiest way to distinguish between “Accrued” and “Deferred” is this: With any deferred expense, money changes hands first. With accrued expenses, it changes hands last.
What Are Some Examples of Deferrals in Accounting?
Here is an example of two companies in a business transaction. It will result in one business classifying the amount involved as a deferred expense, the other as deferred revenue.
Anderson Autos is a company with 8 car dealerships in the Seattle, Washington area. Anderson provides each of his dealerships with magazine and newspaper subscriptions so that customers have something to read while waiting. To get a discount, Anderson pays the full subscription amounts in advance of the renewals. These payments are made at the end of November. The new subscriptions will start in January.
In December, the subscription totals will be accounted for as a deferred expense for Anderson Autos, because the products will not be delivered in the same accounting period they were paid for in. The magazine and newspaper companies will consider these amounts to be deferred revenue, because they haven’t actually incurred any expenses yet to produce the actual magazines, although they have been paid for them.
Why Defer Expenses and Revenue?
A company will defer expenses and revenue so that its financial statements are accurate. This means:
- For a seller, revenue for a product is accounted for at the same time as its production costs are incurred.
- For a buyer, expenses for a product are accounted for when the product is used.
Let’s use a seller example. This time we’ll look at one of the magazine subscriptions that Anderson Autos paid for. The magazine is called “Film Reel” and it is a national entertainment magazine. It focuses on content related to movies that are about to be released into cinemas.
In November, Anderson Autos pays the full amount for the upcoming year’s subscription, which is $602. Now, the accounting department of Film Reel can’t allocate the $602 to sales revenue on its income statement. It can’t, because the magazines haven’t been produced yet, so the cost of goods sold (the costs related to production) cannot be included.
Allocating the income to sales revenue may not seem like a big deal for one subscription, but imagine doing it for a hundred subscriptions, or a thousand. The earnings would be overstated, and company management would not get an accurate picture of expenses vs revenue.
Instead, the amount will be classified as a liability on the magazine’s balance sheet. As each month during the subscription term is realized, a monthly total will be added to the sales revenue on the income statement, until the full subscription amount is accounted for. During these same time periods, costs of goods sold will reflect the actual cost amounts to produce the issues that were prepaid.
Is Deferred Revenue a Credit or Debit?
Debits and credits are used in a company’s bookkeeping in order for its books to balance. Debits increase asset or expense accounts and decrease liability, revenue or equity accounts. Credits do the reverse.
When recording a transaction, every debit entry must have a corresponding credit entry for the same dollar amount, or vice-versa.
Let’s return to Anderson Autos for an example.
Mr. Anderson pays $1904.00 in total subscriptions in November. Again, he hasn’t received a single magazine or newspaper yet for this payment, because he has prepaid. As such, Anderson Auto’s bookkeeper would:
- Debit $1904 to “Prepaid Expenses – Subscription”.
- Credit $1904 to “Cash”.
For more on debits and credits, please consult “What Is a Debit and Credit?”