Accruals and Deferrals

Revenue and expenses should be recognized in the period in which they are earned or incurred. If performance, billing, and cash receipt occur in the same period, then everything aligns smoothly. However, this is often not the case, especially in service contracts, which require adjustments.

There are essentially two types of adjustments based on whether the performance occurred in the past or is expected in the future:

Accrued Revenue and Expenses: These arise when performance has occurred in the past but has not yet been billed by the reporting date.

Deferred Revenue and Expenses: These are applicable when performance is expected in the future, but payment has already been received or billed as of the reporting date.

Accrued Revenue or Income

Accrued revenue, also known by several terms such as unearned revenue, revenue receivable, income earned but not received, and income receivable, refers to revenue that has been earned but not yet recorded in the accounting records. Accrued revenue is classified as an asset and is typically billed within the next twelve months, making it a current asset on the statement of financial position (balance sheet).

Example 1: 

A consultant performs ten hours of work in the last week of January at an agreed rate of $100 per hour. The work is accepted by the client on February 3, after which it is billed and paid. At this point, revenue is recorded in February for work done in January. To rectify this, the accountant credits $1,000 to revenue in January and debits the same amount to the accrued or unearned revenue account on January 31. This entry is reversed at the billing date in February, ensuring revenue is correctly recognized in January.

Note: A question may arise: What if the work is only partially complete? For instance, if 6 hours of work was performed in January and 4 hours in February, no accrued revenue would be recognized at the end of January because the work is not complete. Instead, "work in progress" would be recorded as an asset on the balance sheet.

Example 2: 

Another common instance of accrued income is interest earned but not received during the reporting period. For example, if a company maintains a savings account that accrues monthly interest but pays out quarterly, accrued interest and interest income would be recorded at the end of January. This approach allows interest income to be recognized each month instead of all at once at the end of each quarter.

Accrued Expense

Accrued expenses represent the opposite of accrued revenue and occur when an entity incurs an expense that has not yet been recorded in the financial statements. Accrued expenses are classified as current liabilities on the statement of financial position. In the previous example, the client would record consultancy charges and accrued expenses in January.

Deferred Revenue

If a business sells a service over time but bills upfront, revenue must be deferred and recognized over the performance period. Thus, deferred revenue is classified as a liability on the statement of financial position. This situation is common in rental and subscription service businesses.

Example: 

Odoo, an online ERP provider, sells both monthly and annual subscriptions. For a monthly subscription, payment and billing occur each month, so no deferred revenue arises at month-end. However, for annual subscriptions, revenue must be recorded over the 12-month subscription period. For instance, if an annual subscription is sold for $2,448 on January 1, an invoice is raised, and the customer pays the full amount upfront. Odoo cannot recognize the revenue immediately; instead, it must classify deferred revenue as a liability until it is earned, recognizing it on a straight-line basis over 12 months.

Deferred Expenses

Also known as prepaid expenses, deferred expenses are the counterpart to deferred revenue. In the example above, a client subscribing to a service for 12 months would recognize the expense over that same period, recording a deferred expense as an asset on the balance sheet.