Deferred ExpensesExpenses that are already paid for but are yet to be consumed
Under the accrual accounting method, which is what the US GAAP requires businesses to use, you’ll often find accounts that you won’t see on financial statements that use the cash accounting method.
Among these are those accrual and deferral accounts.
These accounts allow the business to comply with the matching principle.
Depending on the context, an accrual or deferral account may be an asset or a liability.
For example, if it is related to income, an accrual will result in the recording of an asset account.
On the contrary, a deferral will result in the recording of a liability account.
Let’s look more into deferrals.
According to the Merriam-Webster dictionary, deferral refers to the act of delaying or postponing.
So if we apply this to accounting, deferral accounts delay the recording of revenue or expenses.
For example, a deferred revenue account delays the recording of revenue.
A common situation in which the deferral of revenue is necessary is when a business receives payment for an order that is to be fulfilled at a later date.
Since the business still has to fulfill the order, it has yet to earn the associated revenue.
However, since the business has already received payment, it has to record a corresponding credit account, deferred revenue, which is a liability account.
So how does deferral work for expenses?
That’s what we’ll find out in this article.
We will be learning what the term “deferred expenses” means, as well as its significance to your business.
We’ll also be identifying situations that necessitate a business to record a deferred expense account.
By the end of this article, you should have a deeper understanding of what deferred expenses are.
What is a Deferred Expense?
A deferred expense is an expenditure or disbursement in which the corresponding benefit is still yet to be received or consumed.
In other words, it is an “expense” that a business has already paid for.
However, the business only benefits from it at a later date (sometimes, at a later accounting period).
A deferred expense account is an asset account since the business expects to receive benefits from it.
For example, let’s say that a business pays its lessor $72,000 which equates to 3 years’ worth of rent.
Since the business still has to consume the entirety of the lease payment, this necessitates the recording of a deferred expense account.
Let’s say that the business uses the account “prepaid rent” to record the deferral. The corresponding journal entry should look this:
Prepaid rent is an asset account that the business will consume as months go by.
Instead of paying out cash when the rent becomes due, the business amortized a portion of its prepaid rent.
Let’s assume the monthly due is uniform for the next 3 years.
This makes the monthly rent due equal to $2,000.
The corresponding journal entry to record the amortization of prepaid rent should look like this:
Do note that the example above is a simple illustration of a deferred expense account that lasts through several periods (in this case, 3 years).
Businesses will usually only prepay rent equivalent to 1 year’s worth of rent.
Hence, why we used prepaid rent as the deferred expense account as it’s usually the account that records all prepayments related to rent.
This is important to emphasize as there are significant differences between prepaid expenses and deferred expenses.
Deferred Expense vs Prepaid Expense
While the terms “deferred expense” and “prepaid expense” both refer to “expenses” that a business has already paid for but has yet to be consumed, they have their differences.
Hence, if we were to strictly follow accounting rules, the two terms should not be used interchangeably.
If the duration of deferment only lasts a year or less, then it results in the recording of a “prepaid expense”.
For example, if the prepaid rent only covers 12 months or less, then it is a prepaid expense.
On the other hand, if the duration of deferment lasts for more than a year, meaning that it may last through multiple accounting periods, it will result in the recording of a “deferred expense”.
Current or Non-Current Asset?
Now that we know the time duration that prepaid expense and deferred expense accounts cover, it’s time to identify their asset classification in the balance sheet.
Since prepaid expenses are expected to be consumed within a year or less, they qualify as current assets.
On the other hand, deferred expenses are expected to be consumed for more than a year.
This makes them qualify as non-current assets.
If a portion of a deferred expense account is expected to be consumed within a year, the accountant may reclassify that potion as a prepaid expense.
This difference in asset classification is important as it can affect certain financial ratios.
For example, the current ratio uses the total current assets amount as its numerator.
If some deferred expenses were wrongly classified as prepaid expenses, it will result in an overstated current ratio.
Deferred Expense vs Accrued Expense
For those not knowledgeable enough about accounting, they might confuse accrued expenses and deferred expenses simply due to the fact that both terms include the word “expenses”.
The fact is, while both terms relate to expenses, that’s the only similarity between the two.
And just to put this on the table, they’re not expense accounts.
Rather, one is an asset account while the other is a liability account.
A deferred expense account arises from the prepayment of an expense.
This essentially means that the business is paying for a benefit that it will receive later.
For example, a business prepays for a year’s worth of rent. Since the business is still yet to consume rent, the prepayment results in a deferred expense account.
This also makes the deferred expenses account an asset account.
As the business consumes the rent as months go by, it will amortize the prepayment of rent (which is usually recorded as prepaid rent).
On the other hand, an accrued expense account arises when a business incurs an expense but has yet to pay for it.
This creates a liability on the business’s part as it has already received the benefits related to the expense but it hasn’t paid for it yet.
For example, let’s say that a business pays rent every 15th of the month.
This means that the rent for the 16th until the last day of a month will remain unpaid until the 15th of the next month.
This results in the recording of an accrued expense account, which is a liability account.
Basically, the two terms represent opposite scenarios.
Deferred expenses represent expenses that are paid but yet to be consumed.
Meanwhile, accrued expenses represent expenses that are incurred but yet to be paid.
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Cornell Law School "26 CFR § 1.174-4 - Treatment as deferred expenses." Page 1. August 4, 2022
ECFR.gov "§ 1.174-4 Treatment as deferred expenses." Page 1. August 4, 2022