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What is a deferral?

You might think of a deferral as a prepayment of an expense or revenues. Because it is prepaid, it is not recognized immediately on the income statement. Instead, it is deferred to a balance sheet account and will appear later on the income statement.

Let's illustrate with a company whose accounting year ends on December 31. On December 1 the company pays a six-month insurance premium of $12,000. One-sixth of the $12,000, or $2,000, should be expensed and appear on the December income statement. The remaining $10,000 is said to be deferred and will be reported as an asset in the account, Prepaid Insurance, on its December 31 balance sheet. (If the company issues monthly income statements, in each subsequent month the company will reduce Prepaid Insurance by $2,000 and will report the $2,000 as Insurance Expense.)

A deferral also occurs with revenues. For example, the insurance company receiving the $12,000 six-month insurance premium in December should report $2,000 as revenue on its December income statement. The remaining $10,000 should be deferred to a balance sheet liability account, Unearned Premium Revenue. In each subsequent month it should reduce the liability Unearned Premium Revenue by $2,000 and should report $2,000 as Premium Revenue on its income statement.

The journal entries to adjust the balances in the above accounts are referred to as deferral-type adjusting entries or as prepayment-type adjusting entries.