Integrating accruals and deferrals into the accounting process can be critical for ensuring the successful financial management of any company. By accurately tracking and recording all expenses and revenues, businesses can gain a much more comprehensive understanding of how the company is performing, and how operations might be adjusted to facilitate further growth.
In this article, we’ll define accruals and deferrals in terms of both revenue and expenses, highlight the importance of these calculations for startups and small businesses, and briefly explore some other key accounting terms and principles that any expanding organization should be familiar with.
Accruals & deferrals summarized
When a payment is made after services have been rendered or goods have been received and are included in the current fiscal period on your balance sheet, it is referred to as an accrual. On the other hand, a payment that is received before a service has been performed or goods delivered and made to reflect within the following fiscal period is referred to as a deferral.
We dive deeper into both accruals and deferrals below.
What are accruals in accounting?
Accrual refers to a transaction recorded on a financial statement as a debit or credit before the actual payment has been made or received. By accounting for revenue earned or expenses paid, in advance of the transaction, businesses gain a much more accurate, forward-looking view of their finances, which can inform operational adjustments and decision-making.
For the purposes of accounting, accruals are generally separated into two primary categories: revenue and expenses.
Accrued revenue is a payment owed to a company for a product or service that is recognized on an income statement but has not yet been received. For example, if a company expects an interest payment on a loan to be processed at a later date, the loan payment may be listed as accrued revenue or unearned revenue on an income statement for the current period of accounting.
Accrued expenses are payments or liabilities accounted for in advance of the transactions being processed. If a company has a 12-month insurance policy, for example, each monthly payment within the fiscal year may be recognized as an accrued expense even though the company has yet to submit those funds. Similarly, expenses like employee salaries and wages are often listed under current liabilities and recorded as accrued expenses on a company's balance sheet.
How to record accrued expenses
The specific method for recording accrued expenses will depend on a company’s unique accounting process, however, all publicly traded businesses will be required to follow the generally accepted accounting principles (GAAP) as established by the Financial Accounting Standards Board (FASB).
In accrual accounting, accruals are recorded using a journal entry method. For each accounting period, accrued expenses are added to the liabilities side of the balance sheet, as opposed to revenue or assets, and then reversed by adjusting entries once the expense has actually been paid. This accrual basis method allows a business to maintain a consistently accurate view of all existing assets and liabilities at a given time and helps to avoid an overstatement of profit or an understatement of debt.
In the above example of an insurance policy, each monthly payment would be entered as an accrued expense and recorded as cash “credited” to the insurance provider on the balance sheet. After the payment has been made, the entry would be modified to reflect a complete, “debited” transaction to the provider.
What are deferrals in accounting?
A deferral or advance payment refers to a payment for a product or service which has already been made during the current accounting period but that won’t be recorded until after the product or service has been delivered. Deferral accounting can lead to more accurate bookkeeping processes while also allowing an organization to reduce current liabilities on its balance sheet.
As with accruals, deferrals will be broken down into two primary categories: revenue and expenses.
Deferred revenue is a payment made to a company for a product or service that won’t be recorded until after the product or service has been delivered. For example, if a customer pays a company $60 in December for a 6-month subscription at $10 per month, only the first $10 in revenue would be recorded on the income statement for the first month, and the remaining $50 would be deferred to a later accounting period—most likely at year-end, or whichever period corresponds to the subscription’s expiration date.
Deferred expenses are expenses paid to a third party for products or services, but that won’t be recorded until after the products or services have been delivered. A common example of a deferred expense might be a prepaid insurance policy; if a company pays $1,200 upfront for a 12-month policy at $100 per month, only $100 would be listed as an expense for the current accounting period, whereas the remaining $1,100 would be deferred.
By utilizing this strategy of adjusting entries, a business can reduce future liabilities by covering costs for services in advance with prepayments while also improving the accuracy with which it tracks business expenses based on the actual time frames in which those services have been delivered and consumed.
How to record deferred expenses
Much like with accruals, deferrals will almost always be recorded using the journal entry accounting method. In the case of deferrals, however, instead of proactively listing incomplete transactions as expenses, completed transactions are listed as assets until they are converted to expenses at a later date during the fiscal year, typically once all products or services have been utilized or consumed.
Why are accruals and deferrals important for small businesses?
Establishing strong processes around financial reporting and expense management is incredibly important for all businesses but is often particularly critical for small businesses and startups. Here are just three ways that integrating accruals and deferrals into the accounting process can help smaller organizations gain momentum and become more adept at financial planning and analysis.
While many small businesses might initially prefer to utilize simple cash accounting, in which revenue and expenses are always recorded immediately upon receiving or spending funds, this method fails to reveal a more meaningful understanding of the nature of each transaction.
By leveraging accrual and deferral accounting, businesses are provided with a much more precise and accurate illustration of how revenue is generated and expenses are managed throughout each accounting period.
Making strategic adjustments
Once a company has a comprehensive understanding of how finances flow in and out of the organization—based on revenue earned or expenses paid in direct correlation with the delivery of products and services—it becomes considerably easier to evaluate the company’s overall performance and to make the strategic adjustments necessary to achieve continued growth.
Under the GAAP, accrual-based accounting is technically only required of publicly traded corporations, however, small businesses and startups might find it difficult to attract investors without being able to provide them with the uniquely accurate insights that accrual and deferral accounting methods are known to produce.
While cash accounting might show an uptick in sales and a decline in liabilities, it fails to reveal a more in-depth view of how revenue and expenses are generated and managed throughout the organization, and whether or not these processes are sustainable.
3 additional accounting terms all startups should know
Given the inherent complexity and small margin for error, accounting often represents one of the biggest hurdles for small businesses and startups. And while accrual-based accounting can provide myriad benefits for future revenue generation and expense management efforts, leveraging this method effectively requires understanding a variety of associated terms.
Here are just a few terms that your business should know before implementing an accrual-based accounting process:
Accounts payable is where incurred expenses should be logged on a balance sheet before the debt has been officially paid out. Expenses recorded in accounts payable are considered to be liabilities on a company’s balance sheet, and therefore it's important to keep this category up-to-date so as not to misrepresent the amount of debt held by your organization.
Accounts receivable is where incurred revenue should be logged before an actual payment has been received for products and services. This allows your organization to keep track of how much revenue is owed, as well as when you can expect it to be converted into current assets on an income statement.
Expense recognition principle
The expense recognition principle is a best practice that must be observed when utilizing accrual-based accounting as a publicly traded company or for the purpose of attracting investors. It is one aspect of the broader matching principle, which is a primary accounting requirement under the GAAP. In simple terms, the principle requires that any revenue earned as a direct result of a business expense must be recognized along with the expense for the same accounting period.
For example, if your business spends $5,000 on branded merchandise, and then earns $10,000 reselling it on your website, both the revenue and expense will need to be reflected on your income statement within one accounting period.
Streamline expense tracking and financial reporting with Ramp
While the utilization of accruals and deferrals can certainly be beneficial, the success of these methods will be highly dependent on an organization’s individual financial management and accounting processes.
Unfortunately, this is an area where many startups and small businesses tend to struggle—and not because they lack the knowledge or experience, but simply because traditional accounting processes are labor-intensive, time-consuming, and often grounded in outdated technology.
At Ramp, we specialize in delivering modernized accounting, spend control, and expense management solutions to businesses across industries of all sizes and levels of maturity. Through our offering of a single platform to integrate multiple siloed processes, Ramp allows critical management tasks to be executed from one centralized location, while our automation tools work further to remove unnecessary complexities from accounting procedures. Here are just a few ways the Ramp platform can benefit your expense tracking and financial reporting processes:
Too many companies today remain reliant on manually updated spreadsheets to keep track of expenses and manage their books. This process is not only increasingly prone to human error, but can also be a huge waste of valuable time and resources. On average, organizations that have migrated to the Ramp platform have reduced the time it takes to close their books from more than three weeks to just over an hour.
Reduce human error
Crunching numbers before double and triple-checking them for accuracy might once have seemed like an efficient way to track and record expenses, but those days are long gone. By leveraging Ramp’s automation technology, companies can produce an accurate read on all transactions, assign them to a specified category, and all in a fraction of the time it would take to perform these tasks with a manual approach.
In most cases, businesses can automate up to 95% of critical accounting tasks using the Ramp platform, and without the need to compromise quality or attention to detail.
Eliminate audit and compliance concerns
As a small business or startup, it’s critical to remain constantly prepared for a potential financial audit. This can be a huge stressor for many organizations, and the scramble to ensure compliance with reporting obligations can quickly serve as an unnecessary distraction, ultimately eating into the overall productivity of your day-to-day operations.
With Ramp’s unrelenting emphasis on data quality, accuracy, and documentation, it’s possible that you might even look forward to your next financial audit.
Interested in learning more about how Ramp can help your company to more efficiently track and record accrued or deferred expenses?
Click here to get started on the platform today.