What is a Deferred Expense?
Definition: Deferred expense is an accounting term that denotes payments made for goods and services whose consumption would happen in future. Such charges occur when a company or a person pays for items in advance, awaiting delivery or consumption later. Consequently, deferred expenses results in an accounting entry dubbed prepaid expense.
Understanding Deferred Expense In Accounting: Guide
While still a cost, deferred expenses can only affect a business or a company’s profit and loss accounts at a future date once the goods and services are consumed. For that reason, such expenses are recorded in a balance sheet and appear as assets pending their consumption. In a balance sheet, deferred expenses appear in the long-term asset category in the non-current asset sector.
Deferred expenditure can, therefore, be used to denote purchases whose consumptions will occur in the future. Likewise, it is a common phenomenon with big companies or businesses as such expenditures tend to have a significant impact on the income statement. Similar to the practice of deferring expenses is mostly associated with large or more expensive investments.
Small companies rarely deploy the deferred expense practice, as it would make little sense to defer small payments that would not have a significant impact on the income statement. It would also be tiresome for accountants in small businesses to manually enter deferral payments in accounting software. Instead, accountants would often charge the small payments even though they would be incurred in the future.
Deferred Expense Example
Rent on office space is a common type of deferred expense. It is common to find businesses paying rent expenditure in advance. For instance, a business can pay a whole year’s worth of rent. Advertising fees, as well as advance payment of insurance cover, also fit the bill as deferred expenses.
Consider a logistics business purchasing $4000 worth of car fuel while knowing very well that only $1,000 would be enough to run operation in one month. In this case, the business will have to charge the profit and loss account $1,000 to avoid distorting the figures. The remaining $3000 amount is placed in the income statement under the asset section.
Likewise, a company can take an insurance cover and structure payments to be made twice a year. In this case, the company can make one payment of $7000 at the start of the year in January to cater for the first six months of the year. The next payment would be made in June to cater for the remaining six months until December.
Deferred Expense vs. Prepaid Expense
While deferred expense and prepaid expenses are often used interchangeably, they differ slightly depending on the type of expenditure at hand. Deferred expense is mostly used with the deferment of expenditure for more than one year.
A perfect example of deferred expense deals with businesses that issue bonds. Such businesses incur heavy costs as part of the issuance process. The cost goes to cover legal fees as well as investment banking fees for the duration that the businesses issue the bonds, which can be years. It is common to find such businesses depleting the allocated funds over ten years or more.
Prepaid expenses, on the other hand, denotes expenditures whose duration is less than one year. A good example of a prepaid expense would be insurance cover or rent charges that are depleted within 12 months.
While both deferred expenses and prepaid expenses appear as assets in the balance sheet, their categorization is slightly different. Prepaid expenses mostly appear as current assets on the income statement as they last less than one year. Deferred expenses, on the other hand, appear as a non-current long-lived asset in the balance sheet.
Summary
Deferred expense is simply costs that a business pays in advance awaiting consumption at a later date. The charges are billed as assets in the balance sheet until a time when the goods and services paid for are consumed.