Deferring Income – Why Bother?

If you’re an experienced accountant, you’ll already understand why adjustments are made for deferred income, accruals and prepayments. For those new to accounting, however, the terminology can often seem confusing.

At the heart of these adjustments is the accruals basis of accounting. Rather than recognising income and expenses when cash changes hands, businesses recognise them when income is earned and costs are incurred. This helps ensure the financial statements present a fair and accurate picture of the business’s performance during a particular period.

To keep things simple, we’ll avoid technical accounting standards and instead look at a couple of practical examples.

Creating accruals, deferring income and recognising prepayments is not simply about spreading values evenly across months in the profit and loss account. The objective is to ensure income and the costs associated with generating that income are recognised in the same accounting period.

Consider a seasonal business such as a holiday park. Most of its revenue may be generated during the summer months, while there may be periods during the winter when little or no trading activity takes place. That’s perfectly normal.

However, the business may receive deposits, or even full payment, months before customers arrive. A booking made in January for a holiday taking place in July creates cash for the business, but it does not immediately create revenue. The service has not yet been delivered, and the business still has an obligation to provide the holiday.

Another common example is a subscription-based product or service where customers pay annually or quarterly in advance, but receive the service over a much longer period. This means the business receives cash upfront for the full subscription period, even though the service will be delivered over several months.

Although payment is received upfront, the income relates to future periods and should therefore be recognised gradually as the service is provided. Each month, a portion of the deferred income is recognised in the profit and loss account as the business fulfils its obligation to provide the service. This ensures that income is recognised in the same period as the costs incurred to deliver that service.

From an accounting perspective, when payment is received before goods or services are provided, the amount is recorded as deferred income within liabilities on the balance sheet. As the goods or services are delivered, the liability reduces and the income is recognised in the profit and loss account.

This approach provides a more accurate picture of a business’s financial performance and helps ensure that profits are not overstated simply because cash has been received in advance of the work being carried out.