Accrual and Deferral-Finance or Business Ambiguity or Clarity? You Judge...

Accruals and Deferrals

After establishing the significance of accounting through golden rules, we must interpret the concepts of Accrual and Deferrals to establish Matching Principle and Revenue Recognition Principle.

Business/Entity makes the salary payment in cash normally at the end of the month. However, we need to incur the salary expense on daily basis of hours worked, resources/Headcount hired, Headcount resigned etc. Billings depends on these variable factors.

Example- If an employee left in the middle of the month, then its salary expense will be computed based on the number of days worked in a month except for leaves days accounted separately like– Medical leave days, Yearly leave days etc.

Here immerses the concept of Accrual.

Accrual is the method to recognize revenue/income/gains or incur expense/losses periodically against the goods or services delivered irrespective of fact whether Payment is made or not.

Example- XYZ Ltd paid Interest to Debenture holders @ 10% on face value of USD 60,000 at the end of 31st Dec each year.

Problem: Do we need to account this interest payment only at year end.

Solution: No, we need to account this on monthly basis as below.

Calculation of Interest = USD (60,000 * 10%) = USD 6000 annually.

Interest incurred monthly basis = 6000/12 = USD 500

Monthly Accrual Journal Entry - ??Interest on Debentures A/c…DR USD 500

?????????????????????????????????????????????????????????????????????To Interest Payable A/c ??????USD 500

This entry will be posted each month. At year end Dec 31st, Interest Payable will be knocked off from the books for 12 months (500 *12) as shown below.

Year-end settlement of Accrual Entries- Interest Payable… Dr????USD 6000

??????????????????????????????????????????????????????????????????????????????????????To Cash A/c???????USD 6000

Hence, we can see we have incurred interest expenses on periodically basis and completed settlement at financial year close.

Let’s now comprehend the topic Deferral. This is just opposite to Accrual.

Deferral is the method of recognizing advance payment against the goods or services to be delivered in future or contract to be completed in future at a specified date.

Here Revenue, gains, income, expenses, or losses are to be recognized in future period against which payment is received or realized in advance.

Points to Remember

* Revenue is recognized in the books when goods and services is delivered to the customers, or the control or ownership is transferred.

* Expenses are matched with the revenue recognized in the P&L statement periodically.

Ex- if expenses incurred is USD 40,000 in 1st month and total cost estimated to complete the contact is USD 80,000. Then proportionate Revenue to be recognized in 1st month= (40,000/80,000) * 120,000 = USD 60,000.

Example- XYZ Ltd signed a contract with ABC Ltd to deliver the goods at the end of three months. XYZ has also received advance payment for the goods at USD 120,000 on the date of signing the contract.

Problem- How and what should we treat this advance Payment.

Solution- We should treat this Advance Payment as a liability to the entity- XYZ ltd.

Journal Entry at the inception of contract- Bank A/c… Dr ??????????USD 120,000

??????????????????????????????????????????????????????????????To Deferred Revenue A/c ????USD 120,000

Let suppose we recognized equivalent amount of revenue in each month as USD 40,000

Recognized Revenue each month – Deferred Revenue A/c… Dr ??????USD 40,000

???????????????????????????????????????????????????????????????????????????????To Revenue or Sales A/c USD 40,000

At the expiry of contract, deferred revenue will be knocked out of the books.

Concepts are simple and we got to apprise more with the steps of practice and consistent practice.

Stay tuned with another intrigued topic of discussion.