Accrual vs. deferral in accounting: A guide for businesses

Accruals and deferrals are key concepts in accrual accounting, which recognizes revenues and expenses when they happen rather than when cash is exchanged. They help ensure financial statements accurately reflect a business's financial health during a specific period.

For example, the revenue accrues in December if you provide services in December, even if you won’t receive payment until January. If you receive payment for a service to be provided in the future, that’s recorded as deferred revenue until the service is completed.

At a glance: Accrual vs. deferral

Understanding the differences between accrual and deferral is essential for accurate financial reporting.

Here are some of the key distinctions:

What are accruals in accounting?

With an accrual, you record a transaction on a financial statement as a debit or credit before you make or receive the actual payment. By recognizing revenue earned or expenses incurred ahead of the transaction, you’ll gain a more precise, forward-looking perspective on your finances. That helps you make better operational adjustments.

In accounting, you typically divide accruals into two main categories: revenue and expenses.

Accrued revenue

Accrued revenue refers to money your company is owed for a product or service that hasn’t been paid yet. For instance, if you expect an interest payment on a loan to be processed later, you can record that payment as accrued or unearned revenue on your income statement for the current accounting period.

Accrued expenses

Accrued expenses are payments or liabilities recorded before the transactions process. If your company has a 12-month insurance policy, you can recognize each monthly payment within the fiscal year as an accrued expense, even though you haven’t paid those funds. Likewise, you’d often categorize employee salaries and wages as current liabilities and document them as accrued expenses on your balance sheet.

How to record accrued expenses

The way you record accrued expenses will depend on your company’s unique accounting process. However, all publicly traded businesses must be GAAP-compliant.

In accrual-based accounting, you document accruals via journal entries. At the end of each accounting period, accrued expenses appear on the liabilities side of the balance sheet rather than the revenue or asset side, and you move them when the expense is settled. This helps you maintain a view of all current assets and liabilities, avoiding inflated profit or understating debt.

In the insurance policy example above, you’d record each monthly payment as an accrued expense, showing it as cash “credited” to the insurance provider on the balance sheet. After payment, you’d adjust the entry to reflect a “debited” transaction to the provider.

Creating journal entries for accrued expenses

Here’s how to record your insurance policy payment, debiting the appropriate expense account and crediting the corresponding accrued liabilities account:

What are deferrals in accounting?

A deferral or advance payment occurs when you pay for a product or service in the current accounting period but record it after delivery. Deferral accounting enhances bookkeeping accuracy and helps you lower current liabilities on your balance sheet.

As with accruals, you break deferrals up into revenue and expenses.

Deferred revenue

Deferred revenue refers to payments you receive for products or services but don’t record until after those are delivered. If a customer pays $60 in December for a 6-month subscription at $10 per month, you’ll record the initial $10 on the income statement for the first month. You’ll defer the remaining $50 to a later accounting period—typically at year-end or whichever period aligns with the subscription’s expiration date.

Deferred expenses

Deferred expenses are payments to a third party for products or services recorded upon delivery. One example is a prepaid insurance policy. If you pre-pay $1,200 for a 12-month policy at $100 monthly, you’d only recognize $100 as an expense for the current accounting period and defer the remaining $1,100.

This approach to adjusting entries enables you to lower future liabilities by paying for services beforehand. It also enhances the accuracy of monitoring business expenses according to the specific times when vendors provided services or delivered products.

How to record deferred expenses

As with accruals, you record deferrals using journal entries. But instead of listing incomplete transactions as expenses, deferrals treat completed transactions as assets. It converts them to expenses later in the fiscal year, usually when all products and services have been delivered.

Creating journal entries for deferred expenses

Here’s how to record journal entries for the above deferral example.

At the time of payment, you’d record the full amount as a prepaid asset:

At the close of each month, you’d report $100 as an insurance expense and decrease the prepaid insurance account by the same amount:

Why are accruals and deferrals important?

Robust financial reporting and expense management are crucial for all businesses, but they’re especially vital for small businesses and startups. Here are three ways incorporating accruals and deferrals into your accounting process can help your small business develop its financial planning and analysis chops.

Improving accuracy

While many small businesses may initially prefer simple cash accounting, where revenue and expenses are recorded immediately when funds are received or spent, this method doesn’t provide a deeper understanding of each transaction.

Using accrual and deferral accounting, businesses can more clearly see how they generate revenue and manage expenses during each accounting period.

Making strategic adjustments

Once your company better understands how finances flow in and out—based on revenue earned or expenses incurred in direct correlation with the delivery of products and services—it’s much easier to assess your overall performance. From there, you can adjust your strategy for continued growth.

Attracting investors

Under the Generally Accepted Accounting Principles (GAAP) established by the Financial Accounting Standards Board (FASB), accrual-based accounting is technically required only for publicly traded corporations. However, small businesses and startups may struggle to attract investors without offering the insights accrual and deferral accounting methods provide.

Cash accounting might show an uptick in sales and a decline in liabilities. However, it doesn’t give you an in-depth view of how the organization generates and manages its revenue and expenses. And it fails to tell you whether these processes are sustainable.

Understanding related accounting terms

Given its complexity and slim margin for error, accounting is often one of a business’s biggest challenges. Accrual-based accounting offers numerous advantages for generating future revenue and managing expenses, but it requires you to know the lingo.

Here are just a few you should add to your vocabulary:

Accounts payable

Accounts payable is where you should log incurred expenses on a balance sheet before the debt has been officially paid out. Expenses recorded in accounts payable are considered liabilities, so keeping this category up to date is important. That way, you won’t misrepresent your company’s debt.

Accounts receivable

Accounts receivable is where you log incurred revenue before you receive an actual payment for products and services. This allows you to track what you’re owed and when you expect it to convert into current assets on an income statement.

Expense recognition principle

The expense recognition principle is a best practice a company must follow when using accrual-based accounting. It’s one element of the broader matching principle, a fundamental GAAP accounting requirement. In simple terms, it states that you should recognize any revenue earned as a direct outcome of a business expense in the same period as the expense.

‍For instance, if you invest $5,000 in branded merchandise and earn $10,000 reselling it on your website, you must record the revenue and expense on your income statement in the same accounting period.

Streamline expense tracking and financial reporting with Ramp

Accruals and deferrals help provide a clearer perspective on a company’s financial performance, but the accrual method relies on the efficiency of your financial management and accounting practices.

‍Ramp specializes in modern accounting, spend control, and expense management solutions for businesses of all sizes. Here’s how our platform improves expense tracking and financial reporting:

• Save time: ‍Many companies rely on manual spreadsheets to track expenses, which can be time-consuming. Ramp’s automation helps companies cut their book-closing time from over three weeks to just over an hour.
• Reduce human error: Crunching numbers before verifying accuracy may seem like efficient expense tracking, but times have changed. In most cases, Ramp’s automation can automate up to 95% of critical accounting tasks without compromising quality or attention to detail.
• Improve audit readiness: An impending audit can be a huge stressor, and the scramble to ensure compliance with reporting obligations can eat into your overall productivity. Ramp’s unrelenting emphasis on data quality, accuracy, and documentation eases those worries.

‍Learn more about how Ramp can help your company.