A business organization often makes advance payments for good and services. This type of payment is recorded as a deferred expense. It is a cost that has been incurred for a good or a service that has not yet been consumed.
What does deferred expense mean?
A company could pay insurance expenses for the following year in advance. Say, it pays $12,000 in December 2017 as the property insurance premium for the period January 2018 to December 2018. In the month of payment (December 2017), it will record the amount as a deferred expense.
Remember that the deferred expense is recorded as an asset in the company’s balance sheet. It is a current asset as it will be wholly consumed in a year’s time. Every month, $1,000 will be charged as an insurance expense. Consequently, over the 12-month period from January to December 2018, the entire $12,000 will be charged off.
The term deferred expense is often used interchangeably with the phrase, prepaid expense. However, there are times when the two terms are not meant to convey the same meaning. A prepaid expense could refer to a cost that will be wholly consumed in the next 12 months, while a deferred expense could mean a payment that has been made more than a year in advance.
If the terms are used in this manner, a deferred expense will be reflected in the balance sheet as a long-term asset and a prepaid expense will be shown as a current asset.
Example of deferred expense
Lumix, a company that makes electronic components, proposes to move into a new office in April 2018. It pays six months rent in advance at the rate of $5,000 per month. A sum of $30,000 is paid in March 2018 for the period April to September 2018.
This amount of $30,000 is recorded as a deferred expense in its books. Subsequently, it charges an expense of $5,000 every month from April to September. By the end of September, the deferred expense account in its balance sheet is reduced to zero.
A deferred expense is initially recorded in the balance sheet as an asset. As the good or service for which this cost has been incurred is consumed, the amount is charged off to expenses.