Hi,
There are 2 commonly used basis for accounting namely accrual and cash basis.
Cash basis is what most non-business individuals use - income is "recognized" (recorded or reported as income) at the same time it is "realized" (the cash is received) and expenses are recoginzed when the cash is paid.
Accrual basis accounting recognizes revenue when it is earned (the services are provided to the customer or the goods are sold to the customer) rather than when the cash is received. Expenses are recognized in the accounting period when a resource (such as supplies or electricity) are actually consumed rather than when cash is paid.
For example, we consumed electricity in June, but pay for it in July. Under the accrual basis, the expense is "accrued" and reported in June (along with a liability which is an obligation to pay for the electricity). In July, cash is paid and the liability is reduced. Expense is not recorded in July because it was already recorded in June.
Under the cash basis, the revenue would be recognized and recorded when the cash is received in July. We would not use an accounts receivable account because nothing would be entered on the books until we received cash. You can see that the cash method would make it difficult to keep track of credit sales and amounts owed to the business if the cash basis is used.
We also have "deferrals" under an accrual basis. Suppose we bought supplies in June and paid cash for them at the time of purchase, but did not use them until July. Under the accural basis, we would record the supplies as an asset (a resource that will provide benefits in the future) and the payment of cash (but no expense, because we did not consume any of the supplies). We record the expense (and reduce the asset) in July when we actually use them. That is, we have "deferred" recognition of the expense until the supplies were actually used.
Under the cash basis, the expense for supplies would be recognized in June when the cash payment for the supplies was paid.
Accrual means we recognize revenue that has been earned and expenses (resources that have been consumed) for which cash will be received or paid in a future period.
Deferral means we have received cash or paid cash for something we will do for a customer or for a resource that we will consume in a future period.
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In other words accruals are the conditions are satisfied to record a revenue or expense, but money has not changed hands yet. Examples:
Accounts Receivable - work done or goods sold but the customer has not yet paid us
Accounts Payable - expenses incurred but we have not yet paid the supplier
These are recorded before financial statements are prepared, so the statements reflect all revenue earned, and expenses incurred.
Example - Accrued Revenue (accounts receivable)
ComputerRx repairs computers. During March they fixed a computer, but the customer not picked it up or paid by the end of the month. The total value of the work done was $200, including parts, labor, etc.
The company should record both revenue and accounts receivable for $200 each. The work was done by the end of the month. Repair technicians were paid for their time and labor. Parts used in the repairs were also paid for. The company should record both the revenue and related expenses.
Deferrals are the caseswhere money has changed hands, but conditions are not yet satisfied to record a revenue or expense.
Prepaid Expenses - insurance, rent, advertising paid in advance but the expense shows up on future income statements.
Unearned Revenue - subscriptions, maintenance contracts paid in advance but the revenue shows up on future income statements.
These are recorded before financial statements are prepared, so the statements reflect all revenue earned, and expenses incurred. Let's look at a time line and see how it works.
Deferrals are often referred to as allocations. Costs are spread over a number of months using a reasonable method of allocation. In the example below, we use the straight line method - an equal amount is allocated to each month. Other reasonable methods can be used as well.
Hope this is clear.
Rgds
Manish
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