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In accounting, expenses refer to the outflow of economic benefits during a financial period. This definition is crucial in setting apart various spending during that period. Usually, companies write off an expense in the same period as the settlement occurs. However, it may not apply in every case, like for deferred expenses. The accrual principle in accounting can be crucial in determining that.
What is a Deferred Expense?
A deferred expense represents spending for which the outflow of economic benefits will occur later. In other words, it is an advance payment for a future expense. Companies may accumulate deferred expenses from various sources. For example, a company pays a supplier in advance resulting in a deferred expense. It is also known as a prepaid expense.
Companies may accumulate deferred expenses from several sources. Sometimes, suppliers may require an advance fee. Other times, companies may pay advances to secure future services or products. In either case, the payment occurs before the consumption of the related item. Until the company consumes or receives it, the advance payment does not become a part of the income statement.
What is the accounting treatment for Deferred Expenses?
Despite the name, deferred expenses are not actual expenses. Therefore, they do not appear on the income statement. Instead, these expenses are assets a company holds for a specific period. This period may differ based on the contract or agreement with the supplier. Therefore, the initial accounting treatment of a deferred expense is that of an asset. This asset can either be current or non-current.
Once the company obtains the product or service for which it has made an advance payment, it can write off the asset. At this point, it no longer stays as an asset on the balance sheet. Instead, it appears on the income statement as an expense. Deferred expenses may also become a part of other assets, for example, in the case of borrowing costs capitalized as fixed assets.
What is the journal entry for Deferred Expenses?
The journal entry for deferred expenses falls under two stages. The first occurs when a company pays the advance amount. At this point, the company creates an asset on the balance sheet while reducing its cash or bank balance. The journal entry for this stage is as below.
| Dr | Deferred expense (Asset) |
| Cr | Cash or bank |
Once the company consumes or receives the product or services from the supplier, it can remove the deferred expense asset. On the other hand, it must record the expense incurred at that point. The journal entry for this stage is as follows.
| Dr | Expense |
| Cr | Deferred expense (Asset) |
Example
A company, Red Co., pays a $1,000 insurance premium for its vehicles through its bank account. This premium covers a period over the next six months. The company records this payment as follows.
| Dr | Prepaid insurance premium | $1,000 |
| Cr | Bank | $1,000 |
After six months, Red Co. converts the prepaid insurance premium asset to an expense. The journal entry for this transaction is as follows.
| Dr | Insurance expense | $1,000 |
| Cr | Prepaid insurance premium | $1,000 |
Conclusion
Deferred expense refers to spending for which the company has not incurred the expense. It applies in various areas due to the accrual principle in accounting. Despite being known as a deferred expense, it is an asset in the initial stage. Once companies consume the related service or product for it, they can transfer the asset to the income statement.
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