Accruals and deferrals of costs and revenues simply explained

Accruals and deferrals ensure that costs and revenues are assigned to the period to which they actually relate. Without them, the accounts would distort the result and the company would not have a true picture of its financial performance.

Why we use accruals and deferrals

Double-entry bookkeeping works on the principle that what counts is the connection in substance and in time, not the moment of payment. If you pay for something in advance or in arrears, the cost or revenue belongs to the period it actually relates to.

This is precisely why accruals and deferrals matter most at the turn of the year, when payments and supplies often straddle two accounting periods.

Prepaid expenses

These are expenses that you have already paid but that relate only to a future period. A typical example is an insurance premium or a subscription paid in advance for a period that extends beyond the end of the year.

An outlay like this cannot be expensed in full in the year it is paid. Part of it belongs to the following period, in which you actually receive what you paid for.

Deferred income

This is money received in advance for a supply you have yet to provide. For example, a payment for a service that you will only deliver in the following period is recognised as revenue only when you actually provide the service.

Accrued expenses and accrued income

The opposite case is when a cost or revenue has already arisen in the current period, but the money only changes hands later. Such a transaction must also be recorded in the correct period so that the result is right.

• prepaid expenses – paid in advance
• deferred income – received in advance
• accrued expenses – cost now, payment later
• accrued income – revenue now, payment later

The practical impact

Correct accruals and deferrals ensure that the profit or loss is neither artificially inflated nor understated. This is especially important at the turn of the year, when some payments spill over into the next period.

For an entrepreneur, this means a more realistic picture of profit and a better basis both for decision-making and for calculating tax correctly.

A practical example

Imagine that in December you pay an annual insurance premium covering the period until the end of next year. Although you have paid the whole amount now, only the portion relating to this year belongs to the current year’s costs.

The rest is carried over as a prepaid expense to the next year, where it belongs in substance. As a result, neither year is distorted and the profit or loss reflects reality.

Why it matters for reliable financial statements

Accruals and deferrals are one of the pillars that allow the accounts to give a true picture of financial performance. Without them, the results of individual years would shift depending on when payments happened to be made.

• a truer profit or loss in every year
• comparability of financial statements between periods
• a correct basis for calculating tax

When to be careful

Most transactions that need to be accrued or deferred come up at the turn of the year. These are payments that extend into the next period, such as subscriptions, rent or insurance premiums paid in advance.

When closing the books, it is therefore worth going through the documents from the end and the beginning of the year and assessing whether any costs or revenues belong to a different period. Thorough accruals and deferrals save later corrections and ensure that the result is calculated correctly. If you are unsure how to classify a particular transaction, consult an accountant, who will assess which period it belongs to in substance.

Related articles: Receivables and payables ledger: how to keep it efficiently, Valuation allowances and provisions: when to create them, Switching to a financial year: when and how to change your accounting period.

Frequently asked questions

Does a small company also have to use accruals and deferrals?

Accruals and deferrals are applied in double-entry bookkeeping so that the result gives a true reflection of reality. For insignificant, regularly recurring amounts, however, a simplified approach can be used. It is advisable to discuss the specific approach with an accountant.

How do accruals and deferrals differ from a provision?

With accruals and deferrals, both the exact amount and the period to which the transaction relates are known. A provision is created when a liability is probable but its amount or timing is not yet known with certainty.