What is Deferral in Accounting? A Complete Guide

A deferral is used to account for prepaid expenses or early receipt of income. This means paying for a service or product which hasn't been received yet or getting paid for an item which has not been delivered as yet. Deferral permits reflecting of expenses or revenues later on in the financial statements when the product or service has been delivered.

By the end of this guide, you'd be aware of:

• What is deferral in accounting?
• Examples of deferral.
• Treatment of deferral in accounting, with journal entries.
• Whether deferring a payment hurts credit.

What is a Deferral in Accounting?

Deferral, in general, means a company’s prepaid expenses or revenues. A deferral can also be defined as an account where the expenses or revenue is not recognized until the order ends on the balance sheet.

In other words, it is an amount received or paid before the delivery of actual services or products. This makes the amount a revenue or an expense that will reflect in the balance sheet only when the delivery of services has taken place.

A deferral also dictates the kind of adjusting entries made at the time of accounting.

Insurance payments are an example of deferral as the company makes a prepayment for the coverage period. Similarly, a company may also receive a prepayment for an order from a customer.

Prepaid rents, deposits on products, insurance premiums, and service contracts are some of the examples of deferrals.

For understanding how the deferrals are calculated, we shall see some examples in the next sections.

What is an Example of a Deferral?

We can get a firmer grip over the concept of a Deferral with the two examples.

Example 1: Deferred Revenue or Deferred Income

Let’s assume a company that manufactures and deals in industrial equipment. The company receives a lot of orders and for confirmation, many of its customers make a prepayment. The company’s accountant makes a list of all the deferred income. It goes as follows:

Here, we see that the company has received an advance payment of $160,000.

Having received the payment, the company is set to deliver the equipment between January 1 and February 27. The customers will pay the remaining or balance amount once they receive their deliveries. Till this is done, the company will write this amount (that is payable) as deferred revenue in the balance sheet.

Example 2: Deferred Expenses

Now, if the company wants to calculate its deferred expenses which are due to the insurance, here is the table that describes the scenario.

The company pays $15,000 on June 15 for the coverage period of June 30 - December 31. This means that they prepaid the amount. The same goes for the period of December 31 - June 30, when the company again makes a prepayment of $15,000.

So, it can be concluded that because of the prepayment of insurance the company reports  $15,000 as deferred expenses until June 15; when the next payment will be scheduled.

How to Treat Deferral in Accounting?

We have seen that deferred revenue is when the company has received the amount for the service or product that has not yet been delivered. This revenue is, therefore, not counted as revenue by the company at this stage. Now, this revenue which is also termed unearned revenue is recorded as a liability on the balance sheet. This is so because per accrual accounting, the recognition of revenue is not complete.

What is Revenue Recognition?

Revenue recognition is one of the Generally Accepted Accounting Principles (GAAP). It predefines certain conditions to make revenue recognizable and also controls how to account for it. Revenue recognition is usually done when a crucial event occurs and the company can easily measure the dollar amount.

Back to how the deferrals can be adjusted. We must note that an adjusting journal entry is done at the end of the accounting period to recognize if it is an expense or an income that the company has incurred.

The major types of adjusting journal entries are Deferrals, Accruals, and Estimates. We shall focus on the Deferrals here.

What is an Example of Deferral Adjusting Entry?

Having understood the concepts of deferred revenue and deferred expense, let us now move on to the next section. It talks about the respective examples of the two entities.

Head over to our guide on journal entries to learn about adjusting entries and other types of journals you may need.

Adjusting Deferral Revenue

In the case of deferred revenue, the cash is placed in the unearned revenue account. This makes it a liability because the company still owes the goods or services to its customers. This revenue is recognized when the delivery of goods or services actually takes place. At this stage, the liability account is removed.

The table here explains the case of Deferred Revenue and Adjusting Entries.

Deferred Revenue

Adjusting Entries

Adjusting Deferral Expenses

In the case where the expenses are prepaid, there’s a creation of a debit asset account along with the cash payment. The entries are adjusted when the goods are actually consumed. This leads to recognizing the expense and consumption of the asset.

Let’s clear it up with the example of prepaid rent.

Deferred Expense

Adjusting Entries

In this example, the rent is paid for the entire year in advance. The adjusting entries are made at the end of each month throughout the year. This will lead to recognizing the prepayment assets consumed in that particular month.

Adjusting Deferral Expenses

In the case where the expenses are prepaid, there’s a creation of a debit asset account along with the cash payment. The entries are adjusted when the goods are actually consumed. This leads to recognizing the expense and consumption of the asset.

Let’s clear it up with the example of prepaid rent.

Deferred Expense

Adjusting Entries

In this example, the rent is paid for the entire year in advance. The adjusting entries are made at the end of each month throughout the year. This will lead to recognizing the prepayment assets consumed in that particular month.

If there is inflation, the deferred payment will increase. During inflation, the monthly installment will increase as the property seller would want to compensate for the loss of the value due to higher prices. The purchaser will have to consider that an inflation rise of 3-4% would lead to a rise in his payment deferral and the cost of the house would touch the mark of $112,000. So, this could be a disadvantage of deferring a payment in this kind of scheme.

Does Deferring a Payment Hurt Credit?

Deferring is a good option when one has trouble making outright payments. If you are looking to defer your monthly installments for the loan, then you may do so without worrying about the impact on your credit score.

However, there might be factors that would need your attention and consideration:

• Affects overall financial health: Deferring a payment may affect the overall health of your finances in other ways. Your loans will tend to accrue the interest; leading you to pay more in the long run than what you set out for.
  
• Increased monthly payments: Another impact might be on the monthly bills that might increase once your payment resumes.
  
• Late payment charges: Another issue you may face is missing a payment; this will certainly hurt your credit and also trouble you with a late payment charge.

Key Takeaways

Let’s take a quick look at the key takeaways from this article:

• Concept of Deferral: A deferral accounts for prepaid expenses or receipt of early incomes.
• Examples of deferred revenue and deferred expenses.
• Revenue recognition is a principle of accounting that points to particular conditions when the revenue is recognized.
• A deferred payment is a payment where the borrower can pay later even when he gets complete possession of the goods.
• A deferred payment may not hurt your credit but may possibly impact other areas like increased monthly payments or accrued interest.