Deferral: Overview, definition, and example
What is deferral?
Deferral refers to the act of postponing or delaying the recognition or payment of an obligation, such as income, expenses, taxes, or certain financial transactions, to a future period. In accounting, deferral is a method used to recognize revenue or expenses in periods different from when they were initially incurred, based on specific rules or arrangements. Deferral can be applied to various financial items, including tax liabilities, income recognition, and expense recognition, to align with the timing of when they are actually earned or incurred.
In simpler terms, deferral means putting off the recognition or payment of something to a later time, often to better match the timing of related activities.
Why is deferral important?
Deferral is important because it allows businesses and individuals to manage cash flow, comply with tax laws, and recognize revenue or expenses in the periods when they are most appropriate. It helps match expenses to the revenues they generate (the matching principle in accounting) and ensures that financial statements reflect a more accurate picture of an organization’s financial performance. For businesses, deferring payments or income may help with tax planning, managing liabilities, or smoothing out income over time.
For tax purposes, deferral allows taxpayers to postpone certain tax liabilities to future periods, which can provide temporary cash flow relief. It is also important for businesses in complying with accounting standards, such as recognizing income when it is earned rather than when payment is received.
Understanding deferral through an example
Imagine a company receives a prepayment of $10,000 for services to be rendered over the next six months. Rather than recognizing the entire $10,000 as revenue immediately, the company defers recognition by recording the income over the course of the next six months, as the services are provided. This approach ensures that revenue is matched with the period in which it is earned, giving a more accurate financial picture.
In another example, an individual who invests in a retirement account may choose to defer taxes on the income earned in that account until the funds are withdrawn during retirement. This deferral of tax liability allows the individual to benefit from compounding growth without paying taxes in the year the income is earned.
Example of a deferral clause
Here’s how a deferral clause might appear in a tax or accounting agreement:
"The Parties agree that any income received prior to the delivery of services or completion of the project will be deferred and recognized in accordance with applicable revenue recognition principles. The deferral period shall extend until the services are completed or the project is delivered, at which point the revenue will be fully recognized in the financial statements."
Conclusion
Deferral is a useful financial tool that allows for the postponement of recognizing or paying certain financial items, aligning income and expenses with the period in which they are actually earned or incurred. It is commonly used in accounting and tax planning to smooth financial results and provide flexibility in managing cash flow. Understanding when and how deferrals should be applied helps businesses and individuals make informed decisions and comply with relevant standards.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.