Deferred Payment and PrePayment Explained
Definition, Meaning, and Examples
Business Encyclopedia, ISBN 978-1-929500-10-9. Revised 2014-07-25.
"Fly Now Pay Later" plans represent a "deferred payment" situation: Services are delivered before they are paid for. For the seller this is an "accrued revenue" transaction while for the buyer this is a "deferred expense."
A deferred payment situation occurs when goods and services are delivered, and then time passes before they are paid for. A "fly now, pay later" plan is an example of deferred payment situations, as are the so-called "0% financing" plans used as incentives to buy vehicles.
By contrast, a prepayment situation occurs when a buyer pays for goods or services, and a significant time passes before delivery of goods and services. Floorspace rental, for instance is often paid for in this way before the occupancy period. Insurance premiums are paid before the period of coverage.
Accrual accounting practiced by most companies 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.
For 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 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.
For 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 areposted 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-.