When we begin to talk about "deferred" items in relation to accounting transactions, we begin to go further into the reporting side of accounting, and in order to keep this article as simple as possible, we're not going to expand on the relationship of deferred items to balance sheets, profit and loss sheets, etc. We're simply going to define what a deferred expense is, and how you would record such an item.
Deferred expense refers to an item that will initially be recorded as an asset but is expected to become an expense over time and/or through the normal operations of the business. Deferred expenses are sometimes called prepaid expenses, and it is through the use of this term that I believe it makes it easier to understand why it is initially an asset but is later transferred to an expense item.
One of the most basic concepts of accounting involves determining if an item is an asset or a liability. Cash is an asset. Period. It is never a liability; never an expense; never anything but an asset. Cash is a current asset, and serves to increase the net worth of whoever is in possession of the cash. When you exchange cash for expenditure, the transaction relieves the cash journal of the cost of the expenditure, and increases the expense journal by the same amount.
But, what if you pre-pay for an expenditure say, 6 months before you actually use the expense? How do we account for this type of transaction? Enter the term "deferred expense". Every accounting system uses journals that record deferred items; and there generally two major categories of deferrals: deferred expenses and deferred income. The most important aspect of learning to deal with deferred items, is learning to understand what deferred means, and how to recognize an item that should be deferred.
We've defined deferred expenses as an item that is prepaid and is initially recorded as an asset to a business. Let's look at some common sense examples of deferred expenses and explain how to recognize transactions that should be recorded as deferred expenses. Deferred expenses are prepaid insurance premiums, prepaid office supplies, prepaid rentals, and prepaid payroll expense, just to name the more popular examples.
The easiest method for determining if an expense should be classified as a deferred expense is simply to determine "when" the business intends to make use of the expense. If the incurred expense is not to be utilized during the current month, it should be recorded as a deferred expense and an asset to the business. Let's use the example of office supplies: suppose you purchase $3000 of office supplies, and you only use $1500 during the current month. How do you account for the remaining $1500 of supplies? They must be shown as a deferred expense. A failure to properly account for the actual status of an expense item, will distort the profit and loss sheet, and in turn the balance sheet. Although many small businesses do not properly record such transactions, larger more corporate level accounting methods will require accurate recorded transactions of prepaid or deferred expenses.
Information is for educational and informational purposes only and is not be interpreted as financial or legal advice. This does not represent a recommendation to buy, sell, or hold any security. Please consult your financial advisor.