What is deferred expense?
For companies that use accrual accounting (as most businesses do), the term deferred expense (or prepaid expense) refers to the handling of certain expense transactions in the accounting system. The standard textbook definition presents deferred expense as "a cost incurred but not yet consumed."
This means that the buyer has paid for goods or services but not yet received or used them. For instance, when a company buys postal meter postage, the payment is treated by accounting as a deferred expense, and claimed as an asset. When the postage is actually usd, the asset loses value and the deferred expense becomes an ordinary expense.
- What is deferred expense?
- What are frequently occurring deferred expense examples?
- What is the purpose of the deferred expense concept? What are the importtnat practical considerations in using deferred expense?
- Which deferred expense-related termsare importnat to seller and buyer?
- What are prepayment and deferred payment situations?
What are frequently occuring deferred expense examples?
Consider, for instance, a company that ships products through the Postal Service. On the first day of each month, the company might purchase a month's worth of postage for its postage meter account, to cover expected postal service needs for the forthcoming month. Before the service is actually used the expense can be carried in an asset account, "deferred expense." Then, as customer mailings go out over the month, the postage cost can be transformed into an ordinary expense by crediting (decreasing) the deferred expense (asset) account, while simultaneously debiting (increasing) an expense account, such as "product shipping expenses." These transactions could be performed daily, weekly, or even monthly. it is important only that deferred expenses become ordinary expenses in the same accounting period the service is used.
Other frequently used deferred expense examples include the following:
- Insurance premiums, paid before the start of the coverage period. The insured party can Initially carry this cost as a deferred expense account, along with other deferred expenses, or in an asset account of it's own, "prepaid insurance."
- Floor space rental payments paid in advance of occupancy.
- Acquisition cost of assets that will, over the life of the asset, be charged as depreciation expense (tangible assets) or amortization expense (intangible assets).
- Taxes paid in advance of due date are prepaid expenses, carried in a current assets "prepaid expense" account or a current assets "Prepaid taxes" account.
Deferred expense (prepaid expense) transactions of this kind are sometimes called deferred charges, when they refer to one-time or infrequently occurring kinds of transactions, especially when there is a very long period of time between payment and completion of goods or service delivery. Company start up expenses, for instance may be handled as a deferred charge.
What is the purpose of the deferred expense concept? What are the important practical considerations in using deferred expense?
The deferred expense usage in these examples is implemented for the purpose of maintaining accounting accuracy with respect to the matching concept, the universally recognized accounting principle that revenues are to be reported in the same period with the expenses that brought them.
Consider a situation where deferred expense status for a given cost extends across accounting period boundaries. In that case, declaring the full cost as an expense in the first period could mean that first period expenses are overstated, and first period profits are understated. In the same way, the distribution of depreciation or amortization expenses across an asset's depreciable life avoids overstating expenses in the acquisition period.
Accounting principles sometimes come into competition with each other, in which case accountants must choose which principle takes precedence. It is possible, for rigorous application of the matching principle to work against the materiality principle—the idea that trivial matters can be or should be disregarded in financial reporting when they are immaterial. Items are judged "material" if they could individually or collectively influence the economic decisions of financial statement users.
Consider for instance a business that buys a small number of printed postage stamps, or small stocks of office supplies, to be used up across more than one accounting period. Accountants in such cases will likely decide that recording the cost of every stamp or every pencil as a deferred expense, until actually used, would add unnecessary and confusing detail to financial statements, and tedious and unnecessary work for bookkeepers or data entry clerks. They will no doubt choose instead simply to expense these costs in the purchase period. Third-party auditors will no doubt approve this application of the materiality principle.
Which deferred expense-related terms are important to seller and buyer?
A cash payment that creates a deferred expense situation for the buyer creates an unearned revenue situation for the seller (see the encyclopedia entry unearned revenue for examples of the seller's bookkeeping transactions).
Deferred expenses (or prepaid expenses, or deferred charges) are, from the buyer's viewpoint, the opposite of accrued expenses. In the case of accrued expenses, the goods and services are received but not paid for until a later time and the expense accrues (see the encyclopedia entry accrued expense for examples of the buyer's bookkeeping transactions for accrued expenses).
For a deferred expense (or prepaid expenses, or deferred charge), when the buyer pays the seller, the buyer's bookkeeper may enter a debit (increase) for one asset such as prepaid Insurance, and a credit (decrease) for another asset such as cash, as follows:
Journal for Fiscal Year 20YY
145 Prepaid insurance
On the company's income statement for the period, the deferred expense will not contribute to total expenses, and will thus not lower profits this period. That will occur in the period when the deferred expense is recognized simply as an expense, The bookkeeper's journal transactions then might include a debit (increase) to an expense account, such as insurance expense, and a credit (increase) to an asset account, such as prepaid insurance. For example:
730 Insurance expense
What are prepayment and deferred payment situations?
Deferred expenses (prepaid expenses, deferred charges) are handled in accrual accounting in much the same way some other revenue and expense transactions are handled when there is a time lapse between two parts of a business transaction.
Accrual accounting incorporates the matching concept, the idea that revenues should be recognized in the same period with the expenses that brought them. Prepayment and deferred payment situations present a special challenge to the company's bookkeepers and accountants, because it is possible for actual payment and actual delivery to fall in different accounting periods. In order to avoid violating the matching concept, bookkeepers make an initial two entries to register the first transaction event, and then, later, makes adjusting entries to register the second transaction event. For examples of journal entries for each kind of event, see the encyclopedia entries for individual terms, linked below.
Prepayments (payment precedes delivery of goods or services)
- From the seller's viewpoint: The seller will recognize unearned revenues (or deferred revenues) as revenues received for goods and services that have not yet been delivered. Unearned revenues are recorded as liabilities until such time as the goods and services are delivered, after which they may be recognized as earned revenues.
- From the buyer's viewpoint (the subject of this encyclopedia entry): The buyer recognizes deferred expenses (or prepaid expenses or deferred charges), when paying for services or goods before delivery. An inventory of postage stamps, bought but not yet used, is a prepaid expense. When taxes are paid in advance of due date, a prepaid expense is created. Prepaid expenses are recorded as a current asset until the services or goods are delivered or used.
Deferred Payments (delivery of goods or services precedes payment)
- From the seller's viewpoint: Accrued revenues (also called accrued assets or unrealized revenues) are revenues earned by the seller (for delivery of goods and services but which the seller has not yet received. Accrued revenues may be posted in one asset account, such as accounts receivable, until the revenues are actually received. Then, the accounts receivable account (an asset account) is credited (reduced) while the another asset account, cash, is debited (increased).
- From the buyer's viewpoint: Accrued expenses, or accrued liabilities are posted in the buyer's books as a liability, for goods and services purchased and received but not yet paid for. When workers are owed salaries or wages for work completed, but not yet paid for, the employer has an accrued expense. Interest payable for a bank loan can be an accrued expense. Accrued expenses are first entered in the journal as a liability until paid, at which time the liability account is debited (reduced) and an asset account, such as cash, is credited (decreased).
For any company on a cash basis accounting system, however, the bookkeeping practice is much simpler. In cash basis accounting:
- Expenses are recognized when cash is paid
- Revenues are recognized when cash is received.
Deferred expenses (prepaid expenses, or deferred charges) along with the other prepayment and deferred payment situations described above, are used in accrual accounting but not cash basis accounting.