Strictly speaking, a deferral is some type of postponement - it means putting something off until later. In the accounting world, it generally refers to the postponement of recording a transaction until a later accounting period.
For example, if a customer prepays their account by several months, the future payments may be deferred. While you hold onto them, you don't record them in your bookkeeping until they are due. Deferment works in the opposite direction, as well. As a business, if you have any prepaid expenses, you might defer including those payments as expenses in your record-keeping until the resource that has been prepaid is utilized.
One key part of keeping track of your business's financials is to utilize good accounting software so payment deferrals or deferred charges can be easily recorded. Skynova offers accounting software that can help you keep track of income, expenses, and more, including all-in-one invoicing. In this article, we will review what a deferral is in accounting and why small businesses might need to know or use deferrals.
According to the Merriam-Webster Dictionary, the definition of deferral is "the act of delaying." Listed synonyms include deferment, postponement, and delay. In accounting, a deferral refers to money paid or received before a product or service has been provided. What's delayed is the recording of that debt or asset.
You may have heard the word used in other contexts, such as when student loan payments may be deferred by lenders (due to military service or other factors like the COVID -19 pandemic ) or payroll tax deferral meant as economic relief. However, what's being deferred in those cases is payment, not the recording of it, such as with accounting deferrals.
Examples of deferrals in accounting include the following:
- Insurance premiums: Often, a business may pay insurance premiums in a lump sum several months in advance. The application of the payment may be handled in accounting by deferring a portion of the payment and counting it as an expense on a monthly basis over the coverage period.
- Subscription-based services: Many businesses offer subscription-based services and discounts for customers who purchase an annual versus a monthly subscription. The payment for the annual subscription may be treated as a deferral on the business accounting end, applying prorated amounts toward the sales numbers for each month.
- Prepaid rent: In the real estate world, prepaid rent can be treated as a deferral. This often happens when a renter is required to pay first and last month's rent upfront. The property owner will defer the last month's rent, holding it in an account and only applying it toward the last month's rent when the renter gives notice.
- Advertising fees: You might pay to run an ad on a website for several months all at once. Because this service extends over several months, it can make good accounting sense to defer the expense for it and account for a portion of it each month instead.
Note that the deferrals listed above seem to fall into two distinct categories: money paid to the business in advance and money that the business paid to another entity in advance. Exactly how to handle these two types of deferrals is discussed in more detail in the next section.
Detailed Deferral Examples
To fully understand deferrals, we've included two detailed examples showing how a deferral arises and how it's handled in accounting. In general, deferrals in accounting include deferred expenses and deferred revenue.
Deferred Expense Example
Suppose your business must package and ship items to send to customers. To do so, you like to purchase your boxes and packing material in bulk to save money. Often, you purchase enough packing material all at once to last six months. This purchase can be handled as a deferred expense.
Determine the total amount paid for the packing material and then track the amount of material used each month after the purchase. For example, if packing material was purchased for $1,800 on Jan. 1 and $300 worth of the material was used during the month of January, then that amount should be recorded as an expense on the January income statement and the remaining $1,500 will be listed as a deferred expense on the month's balance sheet.
Note that you may wish to break up the total expense equally over the six months if it's easier than tracking the exact amount of material used in a particular month. As long as you are consistent with your chosen method, the numbers should work out fine in the end.
By accounting for the expense of the packing material in this way, you can more clearly track your company's profits and expenses. If the entire cost for the material was accounted for in January, the income statement for January might appear skewed in a negative direction, with costs and expenses outweighing revenue.
Deferred Revenue Example
Now suppose your business offers a subscription service where customers can subscribe to your content and pay on a monthly basis or prepay for the service annually. Since a discount is offered for prepaying for annual service, many of your customers choose this option.
If a customer pays $120 for an annual subscription in March, only $10 of that total should be counted as monthly revenue on the March income statement, with the remaining $110 listed as deferred revenue on the balance sheet. In April, another $10 of the total can be applied toward that month's revenue, while the remaining $100 is deferred, and so on.
Accounting for revenue in this way allows you to keep a better picture of your monthly revenue but also protects you in the event you have to stop the service early and provide prorated refunds to subscribers. Since you will not have counted prepaid money as revenue, but instead have those funds set aside, you can cover the refunds without issue.
What Is the Difference Between a Deferral and an Accrual?
Another accounting term closely related to deferral is accrual. In a way, the two words are opposites of each other. While a deferral is essentially a prepaid expense or a prepayment from a customer, an accrual is an expense incurred but not yet paid (either by the business or by the customers or clients of the business).
Sales on credit are an example of accruals. These sales may be recorded in the month they occur, although their balances have not yet been paid. The amount owed by the customer will be recorded as accounts receivable, which count as assets. Even though the money has not yet been received, it is treated as though it has been, with the expectation that it will be in the future. This is called a revenue accrual.
An example of an expense accrual would be bills owed by your company for services or items already received. Suppose your business hires a lawyer in December to help prepare legal documents and the lawyer doesn't bill for services until January of the following year. In this case, you accrued expenses in December that should be accounted for (possibly retroactively) on December's financial statement even though you didn't pay for those expenses until January.
Let Skynova Help You Manage Your Small Business Accounting
Starting and running a small business is no easy task. Not only is there paperwork to file and things to learn about accounting, but keeping track of invoices and everyday numbers associated with your business can also be a challenge. Keeping track of your current income, making sure you pay taxes to the Internal Revenue Service (IRS) on time, and more can really make your head spin.