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Accruals and deferrals are year-end adjusting entries used to apply the accrual principle, allocating costs and revenues to the year to which they economically relate, regardless of when the payment is made or received.
Attention
Accruals and deferrals do not concern invoices that are simply unpaid or not yet collected, but adjustments necessary to correctly determine the accrual basis of the financial year.
Difference between accruals and deferrals
At the end of the year, two situations may occur:
- Costs or revenues accrued but not yet recorded → Accruals
- Costs or revenues already recorded but not entirely relating to the current year → Deferrals
Simple rule
- Accruals add what is missing.
- Deferrals postpone what has been recorded in excess.
Accrued income and accrued expenses
Accruals concern costs or revenues already accrued in the financial year, but that will have a financial impact (receipt or payment) in the following year.
They are divided into:
- Accrued income → Revenues to be collected
- Accrued expenses → Costs to be paid
The cost or revenue fully relates to the current year, but has not yet been collected or paid.
Prepaid expenses and deferred income
Deferrals postpone costs and revenues already recorded but relating to the following financial year.
They are divided into:
- Prepaid expenses → postpone part of a cost already recorded
- Deferred income → postpone part of a revenue already recorded.
Accruals and deferrals in the chart of accounts structure of Banana Accounting
Accruals and deferrals are recorded through normal entries in the Transactions table, using specific balance sheet accounts in the chart of accounts.
The accounts are listed in the following subgroups:
Current assets
- 1300 Prepaid expenses (costs paid in advance)
- 1301 Accrued income (revenues to be collected)
Short-term third-party capital
- 2300 Costs to be paid
- 2301 Revenues received in advance
Below we present some examples of accrued income and expenses and prepaid expenses and deferred income created in the Transactions table of Banana Accounting
Accounting method and accruals
- In the Accrual basis method or accrual principle, issued or received invoices are recorded directly in the Customers or Suppliers accounts and appear as open items.
- In the Cash basis method, accruals are necessary at year-end to record costs and revenues accrued but not yet collected or paid.
- In the Hybrid system method, the solution most consistent with the adopted recording method is applied.
Case 1 - Accrued income (Revenues to be collected)
Example: the bank grants interest income of CHF 1’200 for the period 01.10–31.03. As of 31.12, 3 months have accrued (October–December).
Portion relating to the current year:
- 1’200 ÷ 6 months × 3 months = CHF 600
Entry on 31.12
- Debit: 1301 Revenues to be collected CHF 600
- Credit: 6950 Interest income CHF 600
In the Income Statement, CHF 600 is shown for the portion of interest income accrued up to 31.12; in the Balance Sheet, accrued income is shown for interest accrued but not yet collected.
Case 2 - Accrued expense (Costs to be paid)
Example: Interest expense on a loan: CHF 2’400 per year, payable on 31.03 of the following year.
As of 31.12, 3 months have accrued.
2’400 ÷ 12 × 3 = CHF 600
Entry on 31.12
- Debit: 6900 Accrued interest expense CHF 600
- Credit: 2300 account Costs to be paid (liability) CHF 600
In the Income Statement, the interest expense accrued up to 31.12 is shown; in the Balance Sheet, the accrued expense is shown for the liability to be paid.
Case 3 - Prepaid expense
Example - Insurance premium paid of CHF 1’200 for 12 months, for the period from 01.10 to 30.09 of the following financial year:
Period relating to the current year:
October–December = 3 months
Portion relating to the current year:
1’200 ÷ 12 × 3 = CHF 300
Portion relating to the following year:
1’200 − 300 = CHF 900
Entry on 31.12
- Debit: Prepaid expenses CHF 900
- Credit: Insurance CHF 900
In the Income Statement, the cost of CHF 300 remains because a reduction of the insurance premium is recorded for the part paid in advance; in the Balance Sheet, CHF 900 remains because it is the portion of cost relating to the following financial year.
Account card of the Prepaid expense
Account card of the Insurance premium expense
Case 4 - Deferred income
Example - Semi-annual rent of CHF 6'000, received in advance on 01.12, for the period from 01.12 to 31.05:
Monthly portion:
6’000 ÷ 6 = 1’000 per month
Portion relating to the current year:
December = CHF 1’000
Portion relating to the following year:
5 months = CHF 5’000
Initial entry:
- Debit: Bank CHF 6’000
- Credit: Rental income CHF 6’000
Entry on 31.12
- Debit: Rental income CHF 5’000
- Credit: Deferred income CHF 5’000 (revenues received in advance)
In the Income Statement, the reduction of rental income must be shown for the part relating to the following financial year; in the Balance Sheet, deferred income is shown for the part of revenue received in advance relating to the following financial year and representing a liability towards the customer.
Account card Rental income
Account card Deferred income for revenues received in advance
Reversal in the following financial year
At the beginning of the new financial year, accrued income and expenses and prepaid expenses and deferred income are reversed.
To reverse, the same accounts that generated the accruals and deferrals are used:
- the accrual and deferral accounts and the cost and revenue accounts are reversed
- or they are offset at the time of payment or collection.
The reversal is necessary to close the accrued income and expenses and prepaid expenses and deferred income accounts.
In summary:
Accruals add what is missing, deferrals postpone what has been recorded in advance.