CPA Exam Review Spotlight (FAR): Accruals and Deferrals
When it comes to accounting, timing is everything. Accruals and deferrals are two of the practices through which both the revenue recognition and the matching principles are applied. Those principles of accounting are two of the pillars on which accrual accounting (i.e., U.S GAAP) stands. So let us examine further what accruals and deferrals are about.
Accruals are recognized in the accounting records because the economic substance of a transaction triggers an accounting entry but not the disbursement or collection of cash. In other words, the chief aim of accounting for accruals is to record the financial transactions of a business in the period in which they occur, rather than in the period in which cash is exchanged. The following are examples of accrual events:
- Sales made “on account”
- Purchases made “on credit”
- Wages expense for employees when they’ve worked but you haven’t yet paid them
- Interest on money borrowed or lent when time has passed (so interest has been earned by the lender) but the actual cash for the interest has not changed hands
- Income tax expense when you owe it but haven’t yet paid the IRS
On the other hand, deferrals arise when cash is received or is disbursed before revenue is earned or benefits are used up, respectively. Here again, it all boils down to timing. The following are examples of deferral events:
- Cash collections for services that have yet to be rendered or products that have yet to be delivered. Revenue is not recognized until the service is performed or the goods are delivered. However, the receipt of cash is an event that needs to be captured in the books. In this situation, the cash account is debited and the deferred (unearned) revenue is credited for the advance in cash received.
- Cash advances for services or products that have yet to be received. Here, the recognition of an expense is delayed until the goods are consumed or services are received. However, the disbursement of cash is an event that needs to be captured in the books.
- For instance, paying rent or insurance in advance triggers a deferral event. In either situation, the cash account is credited and a prepaid account is debited for the advance payment. It’s the passing of the time to which either insurance or rent applies to (usually a month) that triggers the sequential recording of an expense.
- Another example of a deferral event is created when purchasing supplies to be used later. In this case, the cash account is credited and an asset account (supplies on hand) is debited for the amount disbursed. It is the use of the supplies that triggers the gradual recognition of the expense.
- A third example of a deferral event takes place when purchasing an asset to be used up across multiple reporting periods (e.g., property/plant/equipment assets). In this type of situation, U.S GAPP requires that the expense be spread (or that the asset be depreciated) over the accounting periods covered by the useful life of the asset. When the asset is first acquired, the cash account is credited and the relevant property/plant/equipment account is debited for the purchase cost. It’s the passing of an accounting period to which the asset’s useful life applies to that triggers the sequential recording of an expense.
When you think about it, many end of period (monthly/quarterly/yearly) related adjusting entries stems from the necessity to capture all relevant economic events that have triggered accrual and deferral events. As such, no CPA Exam candidate should be surprised if the they get tested on this topic. After reading this write up, I hope the future exam taker will have an easier time differentiating accrual events from deferral events. Please be kind to use the the comments section below to share your own tips on this topic, to ask clarifying questions, or to share your views on what was discussed.