31 Jul Deferral
What is a Deferral?
Definition: 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. </br> </br>
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.</br> </br>
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.</br> </br>
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.