Deferred expense

From CEOpedia | Management online

Deferred expense (also called prepaid expense) is used to describe situation in which cash has been paid or received, but the expense has been postponed to later time. Because of postponement, it represents future benefit to the company and is treated as an asset. It is situation, when expense was not yet incurred so that benefits will be consumed later [1]. During the period it is booked in asset cash and at the end of period it is booked in expense asset. Prepaid expense is for example [2]:

  • deposit,
  • subscription,
  • insurance policy,
  • building,
  • equipment.

Accruals and deferrals context

Deferred expense is one of the four type of adjusting entries. Rest of three are: deferred revenue, accrued liability and accrued asset. Accruals and deferrals are shown is below table [3]:

Type Situation Example Entry during period Entry at end of period
Deferred expense cash is paid, but expense not incurred supplies, rent, insurance policy, buildings, equipment asset cash expense asset
Deferred revenue (called also unearned revenue) cash received, but revenue not earned deposits, subscriptions, gift certificates, rent cash liability liability revenue
Accrued liability expense incurred, but cash not paid salaries, interest, wages, taxes, rent no entry expense liability
Accrued asset revenue earned, but cash not received interest, rent no entry asset revenue

Deferral expense characteristics

All types of adjusting entries, including deferred expense have below characteristics [4]:

  • are internal transactions,
  • do not involve another entities,
  • they never cause increase or decrease in cash,
  • at least one balance sheet account is involved (asset or liability account),
  • at least one income statement is involved (revenue or expense account).

Examples of Deferred expense

  • Insurance: Insurance is a type of deferred expense. Companies pay for insurance coverage in advance, often annually, in order to have protection from losses related to events such as property damage, theft, and natural disasters. At the end of the period, the portion of the insurance cost that has been used is recorded as an expense.
  • Rent: Companies may pay rent for a space in advance, usually on an annual basis. The rent payment is considered a deferred expense and is recorded as an asset on the balance sheet. As the period progresses, the amount of rent used is recognized as an expense and recorded in the income statement.
  • Taxes: Taxes are another type of deferred expense. Taxes may be paid in advance, such as when businesses pay estimated taxes or when they make quarterly payments. The amount of taxes paid in advance is recorded as an asset on the balance sheet, and the amount of taxes used is recognized as an expense and recorded in the income statement.

Advantages of Deferred expense

Deferred expenses offer many advantages to a business, such as:

  • Enhancing cash flow, as expenses are paid now but the benefits are realised later.
  • Easier budgeting, since expenses have already been accounted for and the benefit can be used in the future.
  • Improved cash management, since funds can be allocated for future use.
  • Tax savings, as deferred expenses are tax deductible.
  • Improved financial planning, as expenses can be planned in advance.

Limitations of Deferred expense

Deferred expense has several limitations. These include:

  • Timing: deferring the expense may result in the company having to pay more for the same service or product due to inflation or market changes.
  • Risk: the company may not be able to use the deferred expense if the vendor or product changes.
  • Cash flow: the company may be unable to cover the expense when it is due, resulting in a cash flow problem.
  • Compliance: the company may not be able to comply with certain requirements or regulations if the expense is deferred.
  • Audit: the company may not be able to provide accurate documentation to the auditors if the expense is deferred.

Other approaches related to Deferred expense

  • Accrual method: The accrual method of accounting is used to record transactions when revenues and expenses are earned, regardless of when the actual cash is received or paid. This method allows for the accurate matching of revenues and expenses to the accounting period in which they were earned or incurred.
  • Estimate method: The estimate method of accounting uses estimated amounts to record expenses and revenues when they are incurred or earned, even if the exact amounts are not known. This allows for the recording of expenses and revenues before the actual payments or receipts are made.
  • Straight-line depreciation: The straight-line depreciation method is used to spread the cost of an asset over its expected useful life. This method assumes that the asset will be used evenly over its life and that its value will decrease evenly over time.

In summary, there are three common approaches related to deferred expenses: the accrual method, the estimate method, and straight-line depreciation. Each of these methods provides a different way of accounting for the costs associated with a purchased asset or service. The choice of method will depend on the particular situation and the goals of the business.

Footnotes

  1. ↑ Weygandt J. J., Kieso D. E., Kimmel P. D., (2010), p. 33
  2. ↑ Porter G., Norton C., (2006), p.164
  3. ↑ Porter G., Norton C., (2006), p.164, Weygandt J. J., Kieso D. E., Kimmel P. D., (2010), p. 33
  4. ↑ Porter G., Norton C., (2006), p.164


Deferred expense — recommended articles
Prepaid income — Non capital loss — Accrued income — Nominal account — Accounts uncollectible — Sundry income — Insured value — Unearned premium reserve — Revenue expenditure

References

Author: Dominika Kaczmarczyk

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