Companies have the option to pay expenses forward for certain costs associated with doing business, creating an accounting entry known as prepaid expense or deferred expense. For accounting purposes, both prepaid expense and deferred expense amounts are recorded on a company’s balance sheet, and reductions to each take place at the time the asset is consumed. Because a business does not immediately reap the benefits of the goods or services purchased, both prepaid expenses and deferred expenses are recorded as assets to the company until the expense of the good or service is fully realized. Although prepaid and deferred expenses are advance payment for goods or services, there are clear differences between the two common accounting terms.
Prepaid Expenses
Most purchases a company makes in advance are categorized under the label of prepaid expense. These prepaid goods or services are those a business uses or depletes within a year of purchase, such as rent or property taxes. Until the benefit of the purchase is realized, prepaid expenses are listed on the balance sheet as a current asset. For example, if a company pays its landlord $30,000 in December for rent from January through June, the business is able to include the total amount paid toward current assets in December. As each month passes, the prepaid expense account for rent is decreased by the monthly rent amount until the total $30,000 is depleted. Common prepaid expenses for which consumption takes place within a year include facility rent, property taxes, insurance premiums and interest expenses.
Deferred Expenses
Deferred expenses, also known as deferred charges, are a long-term category of prepaid expenses. When a business purchases goods or services for which consumption does not immediately take place or is not planned within the next 12 months, a deferred expense account is created to be held as a noncurrent asset on the balance sheet. Full consumption of a deferred expense could be years after the initial purchase is made. For example, a business that issues bonds to raise capital incurs hefty costs during the issuance process. These may include legal fees to prepare documentation, investment banking fees for the bond underwriter or fees associated with accounting services, all of which can add up to hundreds of thousands of dollars for the company. The debt issuance fees can be categorized as a deferred expense, and the company can deplete a portion of the costs equally over the 20- or 30-year lifetime of the bond. Other common deferred expenses include startup costs, the purchase of a new plant or facility, relocation costs and advertising expenses.
Both prepaid expenses and deferred expenses are important aspects of the accounting process for a business. As such, understanding the difference between the two terms is necessary to report and account for costs in the most accurate way.