A deferral is an accounting term that refers to the postponement of the recognition of an expense or revenues. There are times when a company may make a payment in advance, but receive the corresponding benefit only at a later date. Similarly, a customer may make an advance payment for a product that is to be supplied after a certain period. In both these instances, the firm would need to defer booking the expense/recognizing the revenue.
What does deferral mean?
A deferral is used by a company to ensure that an expense is recognized in its books in the appropriate accounting period. Similarly, deferrals allow a firm to account for revenue when a sale takes place and not before that.
Suppliers often require companies to make payments in advance for the purchase of raw materials and services. Consider a situation where a firm pays $120,000 as advance rent for 12 months at the rate of $10,000 per month for its office. In the first month, only $10,000 should be considered as a cost. The remaining $110,000 would be deferred and would appear as a prepaid expense in the balance sheet.
Example of deferral
Abacus Consultants, a firm that provides software services, always insists on advance payments from its customers. Most clients opt for a yearly package that requires them to pay the entire sum at the beginning of the contract period.
At the end of December 2017, Abacus holds $12,000,000 in advance payments from its clients. The services against these payments are to be provided in the 12 months from January 2018 to December 2018.
In January 2018, the firm recognizes $1 million as income. The recognition of income against the remaining $11,000,000 is deferred for subsequent months. In February 2018, another $1 million is booked as revenue. The deferral amount appearing in the balance sheet is now reduced to $10,000,000. In this manner, $1 million is recognized every month until December 2018.
A deferral involves the postponement of income or an expense in the books. This practice is followed to ensure that costs and revenues are recognized in the appropriate accounting period.