A Deferred expense results when a buyer has paid for goods or services but not yet received or used them. Not surprisingly, some deferred expenses are also called prepaid expenses.
Deferred Expense in Accrual Accounting
Deferred expense belongs to a family of similar concepts, all made necessary because of the way that accrual accounting handles purchase transactions. The important principle is that firms record expenses only when they actually owe them. And, they do not actually owe payment for goods or services until the seller provides them. As a result, deferred (prepaid) expenses first appear in the buyer's accounting system as assets.
Assets Turn Into Expenses
Many firms, for instance, rent or lease floor space. And, rental or lease contracts normally call for prepayment of monthly occupancy fees, usually by the first day of the month. On the first of the month, therefore, the firm has a deferred expense asset on the books equal to the monthly fee.
This deferred expense asset loses value as the occupancy month passes and the firm claims the occupancy it has just paid for. Asset value reaches 0 by the end of the month and, in its place, the firm records an ordinary expense for the occupancy now past. By the end of the month, that is, the firm actually incurs the expense, as it uses the service.
Explaining Deferred Expense in Context
Sections below further define, explain, and illustrate deferred expense. Note especially that the term appears in context with related terms and concepts such as the following:
- What is deferred expense?
- Define Your Terms! Deferred expense and similar sounding terms.
- Deferred expense turns assets into ordinary expenses over time.
- Familiar examples: Deferred Expenses
- What is the purpose of the deferred expense concept?
- What are the practical considerations in using deferred expense?
- Purchase events from the buyer's viewpoint.
- Summary: Prepayment and Deferred payment terms in accrual accounting.
- Are deferred expenses possible in cash basis accounting?
Quite a few different accounting concepts have names that include the word deferred. The terms deferred expense and deferred cost, for instance, are more or less interchangeable, while deferred payment means something else entirely. To avoid confusion later on, therefore, this article begins with a brief focus on a definition.
Defining Deferred Expense
For those familiar with double-entry accrual accounting, the brief definition may be sufficient:
A deferred expense is an asset, created when an expense is paid but not yet incurred.
For most people, however, a longer definition is more helpful.
A deferred expense results when a buyer pays for goods or services before receving or using them. This expense, in other words, is an asset for the buyer, until the seller actually delivers the goods or services and the expense is therefore actually owed. Upon delivery of the goods or services, the buyer's deferred asset value becomes 0, replaced with an ordinary expense entry in the accounting system.
Exhibit 1, below, shows how five similar terms essentially share this definition.
|All Inclusive interchangeable terms||Deferred Expense|
Used when there is a long time between payment and goods or services delivery
Exhibit 1. Six Deferred Expense terms that differ only slightly in meaning.
Consider, for instance, a firm that ships products through the Postal Service. On the first day of each month, the firm buys a month's supply of postage for its postage meter account. This is to cover shipping charges for the forthcoming month.
Before actually using the postage, the firm carries the expense in an asset account such as "Deferred expense," "Prepaid expense, or "Prepaid postage." Then, as customer mailings go out over the month, the firm transforms the postage cost into ordinary expense with two simultaneous account entries:
- Crediting (decreasing) the Deferred expense (asset) account.
- Debiting (increasing) an expense account, such as Product shipping expenses.
The firm may make such entries 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 common kinds of deferred expenses appear when a firm pays ...
- Floor space rental in advance of occupancy.
- Insurance premiums, before the start of the coverage period.
The insured party can carry this cost in an asset account of it's own, such as "Prepaid insurance."
- For airline tickets before the flight. This creates a prepaid travel expense until the flight occurs.
- Taxes before they are due. This creates a prepaid expense. The firm carries these as in a Current assets account, "Prepaid expense" or "Prepaid taxes."
Deferred Charges vs. Deferred Expenses
Transactions that create a deferred expense sometimes take the name deferred charge. This name applies when they refer to one-time or infrequently occurring kinds of transactions. The term is also appropriate when there is a very long period of time between payment and completion of goods or service delivery.
For this reason, company start up expenses, for instance may be handled as deferred charges.
Firms apply the deferred expense concept in order to maintain accounting accuracy with respect to the matching concept. This is the universally recognized principle that firms report revenues in the same period they report the expenses that brought them.
Consider a situation where deferred expense status for a given cost extends across several accounting periods. In that case, declaring the full cost as a first period expense could result in overstating first period expense. And, this would therefore understate first period profits.
The purpose of deferred expenses compares with the purpose of depreciation and amortization expenses. Distributing these latter expenses across an asset's depreciable life also avoids overstating expenses in the acquisition period.
Accounting principles sometimes work against each other, in which case accountants must decide which principle takes precedence.
Rigorous application of the matching principle, for instance, could work against the materiality principle—the idea that reports should disregard trivial matters. Items are "material" if they could individually or collectively influence the economic decisions of financial statement users.
Consider for instance a business that buys just a few printed postage stamps, or small stocks of office supplies, to be used up across several accounting periods. 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 not be worth the trouble. This kind of attention to minutia adds unnecessary and confusing detail to financial statements. And, it adds 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.
For a deferred expense, when buyer pays seller, the buyer may make two accounting system entries:
- Firstly, a debit (increase) for one asset account (such as "Prepaid Insurance").
- Secondly, a credit (decrease) for another asset account, such as "Cash."
Exhibit 2 shows how these entries appear in the buyer's journal.
Journal for Fiscal Year 20YY
145 Prepaid insurance
Exhibit 2. Initial journal entries creating a prepaid expense asset (Prepaid insurance).
Accounting Entries When Closing Out the Sale
When the seller actually delivers the goods or services, the buyer may close out the sale transaction with two more journal entries:
- Firstly, a debit (increase) to an expense account, such as "Insurance expense."
- Secondly, a credit (increase) to an asset account, such as "Prepaid insurance."
Exhibit 3 shows how these entries appear in the journal.
730 Insurance expense
Exhibit 3. The buyer's journal entries after the seller delivers goods and services.
Note especially that the the firm may or may not actually receive or use the service in the same period it pays for it. The firm's bookkeepers and accountants will invoke the matching concept, so as to report expenses in the period they incur them.
- If the firm does pay for and use the services in the same period, it may close out the sale by making the two entries in Exhibit 3. In that case, they subtract Insurance expense—along with other expenses—from revenue to calculate profits for the period.
- If the firm does not use the services in the same period, the period ends with just the two journal entries in Exhibit 2 in place. And, on the firm's income statement for the period, the deferred expense does not contribute to total expenses, and therefore does not lower profits this period.
Accrual accounting recognizes that even the simplest purchase transaction requires two accounting entries by the buyer, and two by the seller. This is because every purchase is complete only after two events occur:
- The buyer pays.
- The seller delivers goods or services.
In ordinary retail shopping, the two events occur essentially at the same time. However, In business, especially, the two events may occur days or weeks apart, and in either order.
- In the deferred expense situation, payment comes first.
- When the seller sells "on credit," however, delivery comes first. This is the opposite of the deferred expense situation.
Note that seller and buyer have a debtor-creditor relationship for the time period between these events, regardless of which comes first.
An Abundance of Terms
Deferred expense terms above are just a subset of a larger group of purchase payment-related terms in accrual accounting. Exhibit 4, and the discussion below present a more complete summary of the various accounting entries buyers and sellers make, when purchases are paid for and when they are delivered.
|Account Entries||When Payment Precedes Delivery|
|Buyer View||Seller View|
|Incur Expense||Earn Revenues|
|Account Entries||When Delivery Precedes Payment|
|Buyer View||Seller View|
|Reduce Liability||Earn revenues|
Exhibit 4. Buyer and seller accounting entries depend on the order of payment and delivery events.
Prepayment Situation: Payment Precedes Delivery of Goods or Services
Prepayment 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 delivered. Unearned revenues appear as liabilities until such time as the seller delivers goods and services, after which they are earned revenues.
Prepayment From The Buyer's Viewpoint
The buyer recognizes deferred expenses when paying for services or goods before delivery. When firms pay taxes in advance of due date, they create a prepaid expense. They record prepaid expenses as a Current asset until the seller actually delivers the services or goods.
Deferred Payment Situation: Delivery of Goods or Services Precedes Payment
Deferred Payment from The Seller's Viewpoint:
Accrued revenues (also called accrued assets or unrealized revenues) are revenues the seller earns (for delivery of goods and services) but which the seller has not yet received. Accrued revenues may post as "Accounts receivable" until the seller actually receives cash payment. When payment arrives, the firm credits (reduces) "Accounts receivable," an asset account, while debiting (increasing) another asset account, "Cash."
Deferred Payment From the buyer's Viewpoint:
Accrued expenses, or accrued liabilities post in the buyer's books as a liabilities for goods and services received but not yet paid for. And, when a firm owes employees salaries or wages for work completed, the employer has an accrued expense. Also, Interest payable for a bank loan can be an accrued expense. Accrued expenses appear in the journal and ledger as liabilities until the firm pays. When they pay, they debit (reduce) the liability account and at the same time credit (reduce) an asset account, such as "Cash."
For any firm on a cash basis accounting system, however, the accounting practice is much simpler. In cash basis accounting. Cash basis firms ...
- Recognize expenses when they pay them, in cash.
- Recognize revenues when they receive them, in cash.
Deferred expenses, along with the other prepay and deferring situations simply do not appear in cash basis accounting.