Prepaid expenses

Definition

Deferred expenses, also known as prepaid expenses or prepayments, are costs for goods and services that have been paid for prior to the recognition of an expense in the current period. Deferred expenses are recorded as an asset, then amortized or written-off over the course of multiple periods, depending on the terms of the arrangement.

For the stake holders of the company, understanding how deferred expenses are recorded, classified, and reported on the financial statements is important for determining the financial health of the business, in comparison to peers and industry.

Overview

Deferred expenses represent payments made by a company in advance of receiving goods or services from a vendor. The payments are recorded as an asset on the balance sheet as long as there are no time restrictions that limit the period of time that can pass before a refund is required. When the period of time passes, or a company receives services from a vendor included in the payment, the asset is amortized over the period of time it covers.

An example would be if a janitorial service was paid $500.00 six months in advance to clean and maintain the office each month. Since the prepaid amount was received prior to the six months of services provided, the $500.00 is classified as an asset and is amortized as an expense over the six-month period.

The most common type of deferred expenses include prepaid rent, prepaid insurance premiums, prepaid advertising, prepaid royalties and licenses, and subscription payments.

Amortization

When it comes to amortizing deferred expenses, companies should always be sure to consider their unique set of circumstances. Depending on the item, the start and end dates of the service/goods provided, and the industry, U.S. Generally Accepted Accounting Principles (GAAP) and IRS guidelines should always be taken into account.

For example, most assets are amortized over the life of the asset (meaning, the period of time that it can be used) or on a straight-line basis. Straight-line amortization means that the asset is amortized evenly over the period of time that it is utilized.

For example, say a company signs a term lease for its office space. The annual cost of the lease is $12,000. On a straight-line amortization basis, the company would record an expense of $1,000 per month on its income statement.

Taxes

When it comes to tax implications, deferred expenses are not taxable until they are recognized as an expense on the income statement. Any prepayment related to a tax expense or deductible item is not deductible until it is recognized as an expense in an appropriate taxable period.

When making payments for expenditures which may be deductible as a current expense, it is important to distinguish between those deductions which may be taken as a one-time deduction and those which must be taken over a period of time. For instance, the IRS generally permits a one-time deduction for prepaid rent payments made more than 12 months in advance.

Conclusion

Deferred expenses, also known as prepaid expenses, represent payments made by a company in advance of receiving goods or services from a vendor. When the goods or services are received, the asset is generally amortized over the period of time that it covers.

It is important to understand how deferred expenses are recorded, classified and reported on the financial reports. This knowledge is especially important when it comes to taxes as prepayments related to tax expenses or deductible items are not deductible until they are recognized as an expense in an appropriate taxable period.

Deferred expenses, also referred to as prepaid expenses, are expenses that have been paid for an item or service, but that are not yet used up. In other words, they are expenses that are paid before they are used, and they are expected to be used up in the future. The accounting treatment of deferred expenses is to record the expense in the books when it is paid and to recognize it as an asset until it is used. Deferred expenses can be classified according to two criteria, the duration of payment and the nature of the asset or service.

The most common type of deferred expenses is those that are paid over an extended period of time. These include lease payments, insurance premiums, and other payments that are made in monthly or quarterly installments. When the payment is made, the business records the expense as an asset, which is known as a deferred expense account. When the asset is used up, the expense is then recognized as an expense.

In addition to the extended payment of deferred expenses, there are short-term expenses that are paid in advance but are expected to be used up within a short time period. Examples of short-term deferred expenses include advertising expenses, short-term maintenance costs, and other prepaid expenses. Once the asset is used up, the expense is recognized.

Another way to classify deferred expenses is according to the nature of the asset or service. For example, some assets, such as fixtures and equipment, require an upfront payment but will eventually be used up over the course of time. Other assets or services, such as materials and labor, are typically prepaid and then used up in the near future. In both cases, the expense is recognized when it is used up.

Although the accounting treatment of deferred expenses can be complicated, it is important for businesses to properly record their deferred expenses in order to accurately reflect their financial status. By understanding the proper way to recognize and report these expenses, companies are able to make informed decisions about their financial obligations.