Question

What are the differences between accrual entries and deferral entries?

What types of accounts are typically affected by these two types of entries?

Explain why accrual and deferral entries do not pertain to the cash method of accounting

Answer 1

An accrual occurs before a payment or receipt. A deferral occurs after a payment or receipt. There are accruals for expenses and for revenues. There are deferrals for expenses and for revenues.

An accrual of an expense refers to the reporting of an expense and the related liability in the period in which they occur, and that period is prior to the period in which the payment is made. An example of an accrual for an expense is the electricity that is used in December, but the payment will not be made until January.

An accrual of revenues refers to the reporting of revenues and the related receivables in the period in which they are earned, and that period is prior to the period of the cash receipt. An example of the accrual of revenues is the interest earned in December on an investment in a government bond, but the interest will not be received until January.

A deferral of an expense refers to a payment that was made in one period, but will be reported as an expense in a later period. An example is the payment in December for the six-month insurance premium that will be reported as an expense in the months of January through June.

A deferral of revenues refers to receipts in one accounting period, but they will be earned in future accounting periods. For example, the insurance company has a cash receipt in December for a six-month insurance premium. However, the insurance company will report this as part of its revenues in January through June. similary your school/college fees which is taken in advance will be booked later on

There are four types of adjusting journal entries & Therefore the following accounts will be affected

1)Accrued Revenues:
Accrued revenue occurs when you make a sale and collect payment at a later date. An adjusting entry to record accrued revenue increases the revenue account and the accounts receivable account by the amount of the sale. Accounts receivable shows the amount customers owe you. For example, assume your small business sold a $500 product in the current period and will collect payment in the next period. You create an adjusting journal entry in the current period that adds $500 to your revenue account and adds $500 to accounts receivable.

2)Accrued Expenses
An accrued expense is one that you incur but have not yet paid. An adjusting entry to record an accrued expense increases the expense account that corresponds to the expense incurred and increases the appropriate payable account. A payable account shows the amount you owe other parties. For example, if your small business accrues a $1,000 expense for salaries in the current period and will pay your employees in the next period. You add $1,000 to the salaries expense account and to the salaries payable account in an adjusting journal entry.

3)Deferred Revenues
Deferred, or unearned, revenue occurs when you receive cash up front for services you will provide in the future. As you provide the services to earn the revenue, you create an adjusting entry that increases the revenue account and reduces the unearned revenue account by the amount earned. For example, assume your small business collected $100 at the beginning of the month to provide a monthly service. At the end of the month, you create an adjusting entry that adds $200 to the revenue account and reduces unearned revenue by $200.

4)Deferred Expenses
A deferred, or prepaid, expense is one for which you paid cash up front at an earlier date but which you have not yet incurred. As you incur the expense, you create an adjusting entry that increases the appropriate expense account and reduces the prepaid expense account. For example, if your small business prepaid $4,000 for rent at the beginning of the month. You create an adjusting entry at the end of the month that adds $4,000 to the rent expense account and reduces the prepaid rent account by $4,000.

The cash-basis and accrual-basis are two different approaches that can be used to record the financial transactions of a business.

The cash-basis is quite simple to understand and maintain while the more complicated accrual-basis produces the more accurate assessment of the financial position and performance of the business.

The major difference between the accrual accounting method and the cash accounting method is the way in which revenue and expenses are recorded in the accounts of the business. This difference consequently leads to a different profit result for a given period depending on the approach adopted. This difference is detailed below:

a)Cash-basis - Using the cash-basis, revenue is only recorded when the cash is actually exchanged i.e. when revenue is received as cash and when expenses are actually paid.

b)Accrual-basis - By contrast, the accrual-basis records revenue at the moment that a legal obligation is created. (i.e. at the point when the goods are shipped or at the completion of a service for a customer regardless of when the cash is actually exchanged). Similarly, under the accrual accounting method, expenses are recorded the moment a business becomes legally obliged to pay the bill (i.e. at the point of goods receipt or at the completion of the service by a supplier).

Another key difference between the accrual accounting method and the cash accounting method is that the accrual accounting method properly applies the accounting concept of the 'matching principle' while the cash accounting method does not.

Applying the matching principle in accounting, requires you to record revenue/expenses in the same period, the revenue and all the expenses incurred in earning that revenue. The matching principle ensures that profits (revenues less expenses) are accurately reported for each accounting period. i.e. revenue earned in one period is accurately matched against the expenses that correspond to that same period, so a truer picture of your net profits for each period can be calculated.

For this reason, the accrual accounting method requires end-of-period adjustments to be made to the business revenues (i.e. adjusting for unearned revenue) and expenses (i.e. adjusting for pre-paid expenses) while the cash accounting method doesn't. These end-of-period adjustments create accounting transactions known as accruals.

EXAMPLE:

METHOD	CASH ACCOUNTING METHOD	ACCRUAL ACCOUNTING METHOD
BUSINESS RECIEVED $500 IN APRIL FOR WORK COMPLETED IN MARCH	RECORD $500 REVENUE IN APRIL	RECORD $500 REVENUE IN MARCH
BUSINESS PAYS $400 TELEPHONE BILL OF JANUARY IN FEBURARY	RECORD $400 AS TELEPHONE EXPENSE IN FEBURARY	RECORD $400 AS TELEPHONE EXPENSE IN JANUARY