Deferred Expense, Prepaid Expense, Deferred Charge Explained
Definitions, Meaning, and Example Transactions
Business Encyclopedia, ISBN 978-1-929500-10-9. Revised 2013-03-10.
For companies that use accrual accounting (as most companies do), a deferred expense (or prepaid expense) is a term that refers to the handling of the transaction in the buyer's accounting system. This is an expense the buyer has actually paid, but not recognized as an expense for the period when payment is made. Instead, the buyer initially records payment as an asset that will be written off (recognized as an expense) in a future period after the goods or services for the payment are received. Examples include rent payments paid in advance, or insurance premiums paid for before the term of coverage.
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.
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 bookkeepers 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
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.
By Marty Schmidt. Copyright © 2004-.