Companies have the option to pay expenses ahead of certain costs associated with doing business. This can create an accounting entry on the balance sheet known as a prepaid expense or deferred expense. For accounting purposes, both prepaid expense and deferred expense amounts are recorded on a company's balance sheet and will also affect the company’s income statement when adjusted.
Since a business does not immediately reap the benefits of their purchase, both prepaid expenses and deferred expenses are recorded as assets on the balance sheet for the company until the expense is realized. Both prepaid and deferred expenses are advance payments, but there are some clear differences between the two common accounting terms. As discussed below, one of the key differentiators is time. Assets and liabilities on a balance sheet both customarily differentiate and divide their line items between current and long-term.
Many purchases a company makes in advance will be categorized under the label of prepaid expense. These prepaid expenses are those a business uses or depletes within a year of purchase, such as insurance, rent or 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 in its 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.
Deferred expenses, also known as deferred charges, fall in the long-term asset category. When a business pays out cash for a payment in 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 will 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 may 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.
As a company realizes its costs, they then transfer them to the income statement, decreasing the bottom line. The advantage here is that the expenses are more spread out with less of an effect on net income.