Examples of Accounting Deferrals

In accounting, transactions are entered as debits or credits to accounts. A debit entry signifies an increase in an asset -- something owned -- or a decrease in a liability -- something owed -- while a credit entry to these accounts indicates the exact opposite. While most cash transactions are entered immediately, an entry for revenue or an expense may be entered long after cash is paid or received. This is called a deferral.

A deferral involves either the receipt of cash before revenue has been earned or payment of cash before an expense is incurred. When you incur an expense, you make a debit entry to the expense account. If a business owner purchases $1,000 worth of supplies, that does not mean the company has incurred an expense. The cost of the supplies used up over time is entered as the expense. For example, if $1,000 of supplies were purchased on February 1, the proper accounting entries are a $1,000 debit entry to the supplies account and a $1,000 credit entry to the cash account. If on May 31 an inventory check reveals that there are $600 of supplies remaining, the manager will make a $400 debit entry to the supplies expense account and a $400 credit entry to the supplies account: $1,000 minus $600 equals $400.

A prepaid expense account is an asset account that is purchased in advance, such as an insurance policy. If a company purchases a six-month policy for $600, the expense is not recorded until the policy expires. The initial entry is a $600 credit to the cash account and a $600 debit to the prepaid insurance account. When the policy has been in effect for one month, $100 is entered as a debit to insurance expense and as a credit to prepaid insurance: $600 divided by six months equals $100. The entry to insurance expense is not made when the cash is spent; it is deferred until the expense is incurred.

Deferred revenue occurs when cash has been received but revenue has not been earned. When you earn revenue, you make a credit entry to a revenue account. An example is a business selling a magazine subscription of 12 issues at the start of the year for $36. The correct entry on January 1 is a debit entry of $36 for the cash account and a credit entry of $36 to unearned revenue. Each month a magazine is sent to the customer, an entry of $3 is made to the debit column of unearned revenue and to the credit column of sales: $36 divided by 12 months equals $3. The entry to the sales account is not made on January 1; it is deferred until the revenue is actually earned.

Deferring revenues and expenses is necessary to provide accurate financial information for a specific time period. Entering an expense before it is incurred will cause net income for that period to appear lower than it actually is. Entering a payment as revenue before it is earned will make a period appear more profitable than it is. Managers and investors depend on accurate financial information when making decisions, which is why it is vital that expenses are entered when they are incurred and revenue is entered when it is earned.