A deferred expense results when a buyer pays for goods or services but does not receive or use them for some time. The term prepaid expense describes the same situation.
Deferred Expense in Accrual Accounting
"Deferred expense" belongs to a family of similar concepts, all necessary because of the way that accrual accounting handles purchase transactions. The vital principle is that firms record expenses only when they owe them. And, they do not 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 typically call for prepayment of monthly occupancy fees, usually by the first day of the month. At the beginning 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 bought. 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. Over the occupancy month, that is, the firm incurs the "expense," as it uses the service.
Explaining Deferred Expense in Context
Sections below further define and illustrate Deferred Expense in context with related terms and concepts, emphasizing three themes:
- First, defining deferred expense and showing how firms use the concept to turn expenditures of assets into ordinary expenses over time.
- Second, how accrual accounting uses "deferred" and "accrued" concepts to implement the accounting matching concept, and achieve accounting accuracy.
- Third, example transactions for a single sales action as seen by sellers and as seen by buyers.
- What is a deferred expense?
- Define Your Terms! Deferred expense" and similar sounding terms.
- Deferred expenses turn 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 focus on definitions.
Defining Deferred Expense
For those familiar with double-entry accrual accounting, this brief definition may be sufficient:
A deferred expense is an asset that comes into existence when a firm pays the expense before incurring it.
For most people, however, a longer definition is helpful.
A deferred expense results when a buyer pays for goods or services before receiving them. This expense, in other words, is an asset for the buyer, until the seller delivers, at which time the buyer incurs (owes) the expense. 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||
Generally applies to recurring kinds of purchases
Applies 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 purchase is to cover shipping charges for the forthcoming month.
Before 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 essential only that deferred expenses become ordinary expenses in the same accounting period as service consumption.
Other common kinds of deferred expenses appear when a firm pays the following:
- 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 its own "Prepaid insurance" account.
- For airline tickets before the flight. This purchase creates a prepaid travel expense until the trip occurs.
- Taxes before they are due. This payment 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 deals. The term is also appropriate when there is a very long period between payment and completion of goods or service delivery.
For this reason, company "startup expenses," for instance may register as "deferred charges."
Firms apply the deferred expense concept to maintain accounting accuracy concerning the "matching concept." This concept is the universally recognized principle that firms report revenue earnings 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 value 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 intention 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 rule 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 use 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 using it, 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 merely 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 the buyer pays the 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 that create a prepaid expense asset (Prepaid insurance).
Accounting Entries When Closing Out the Sale
When the seller 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 seller delivery of goods and services.
Note that the firm may or may not receive or use the service in the same period it pays for it. The firm's bookkeepers and accountants will invoke the matching concept, 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 Income statement "total expenses," and therefore does not lower profits for this period.
Accrual accounting recognizes that even the most straightforward purchase transaction requires two accounting entries by the buyer, and two by the seller. These four transactions are necessary because every purchase is complete only after two events occur:
- The buyer pays.
- The seller delivers goods or services.
In conventional retail shopping, the two events occur mostly at the same time. However, In business, especially, the two may happen 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 order is the opposite of the deferred expense situation.
Note that the seller and buyer have a debtor-creditor relationship for the timespan 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 summarizes more of the various accounting entries buyers and sellers record when paying for and delivering purchases.
|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 the seller provides the products, 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 before they are due, they create a "prepaid expense." They record prepaid expenses as a Current asset until the seller 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 receives the 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 liabilities for goods and services received but not yet bought. 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 more straightforward. 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 do not appear in cash basis accounting.