Accounting Transactions: Deferred Expense

When we begin to talk about deferred items in relation to accounting transactions, we begin to go further into the reporting side of accounting, and in order to keep this article as simple as possible, were not going to expand on the relationship of deferred items to balance sheets, profit and loss sheets, etc. Were simply going to define what a deferred expense is, and how you would record such an item. Deferred expense refers to an item that will initially be recorded as an asset but is expected to become an expense over time and/or through the normal operations of the business. Deferred expenses are sometimes called prepaid expenses, and it is through the use of this term that I believe it makes it easier to understand why it is initially an asset but is later transferred to an expense item. One of the most basic concepts of accounting involves determining if an item is an asset or a liability. Cash is an asset. Period. It is never a liability; never an expense; never anything but an asset. Cash is a current asset, and serves to increase the net worth of whoever is in possession of the cash. When you exchange cash for expenditure, the transaction relieves the cash journal of the cost of the expenditure, and increases the expense journal by the same amount. But, what if you pre-pay for an expenditure say, 6 months before you actually use the expense? How do we account for this type of transaction? Enter the term deferred expense. Every accounting system uses journals that record deferred items; and there generally two major categories of deferrals: deferred expenses and deferred income. The most important aspect of learning to deal with deferred items, is learning to understand what deferred means, and how to recognize an item that should be deferred. Weve defined deferred expenses as an item that is prepaid and is initially recorded as an asset to a business. Lets look at some common sense examples of deferred expenses and explain how to recognize transactions that should be recorded as deferred expenses. Deferred expenses are prepaid insurance premiums, prepaid office supplies, prepaid rentals, and prepaid payroll expense, just to name the more popular examples.

The easiest method for determining if an expense should be classified as a deferred expense is simply to determine when the business intends to make use of the expense. If the incurred expense is not to be utilized during the current month, it should be recorded as a deferred expense and an asset to the business. Lets use the example of office supplies: suppose you purchase $3000 of office supplies, and you only use $1500 during the current month. How do you account for the remaining $1500 of supplies? They must be shown as a deferred expense. A failure to properly account for the actual status of an expense item, will distort the profit and loss sheet, and in turn the balance sheet. Although many small businesses do not properly record such transactions, larger more corporate level accounting methods will require accurate recorded transactions of prepaid or deferred expenses.
Adjusting Journal Entries All adjusting entries (other than error corrections) will always involve at least one account on the balance sheet and at least one account on the income statement. I. Deferral Adjustments A deferral involves a past exchange of cash that has initially been recorded on the balance sheet rather than on the income statement. The name deferral comes about because the recording on the income statement is deferred (postponed) to a later time. A. Deferred Expenses A deferred expense is initially recorded on the balance sheet as an asset than being immediately expensed. An adjusting entry becomes necessary as the asset is consumed and becomes an expense. 1. Illustration for a short-term asset > Past exchange of cash Asset Cash XXX XXX

> Adjusting entry necessary as the asset is consumed Expense statement) Asset XXX (Income

XXX (Balance sheet)

Example: The supplies account currently shows a $300 balance. A count of the supplies determines that only $250 remains. Supplies Expense Supplies 2. Illustration for a long-term asset The adjusting entry for long-term assets differs in that instead of reducing the asset directly, a contra account is used that is subtracted from the asset on the balance sheet. > Past exchange of cash Asset Cash XXX XXX 50 50

> Adjusting entry necessary as the asset is consumed Depreciation Expense statement) Accumulated Depreciation (Balance sheet) XXX XXX (Income

Example: Current year depreciation is $2,500. Depreciation Expense Accumulated Depreciation that is subtracted from the asset on the balance sheet. It has a normal credit balance. B. Deferred Revenues A revenue cannot be recorded until the income has been earned. Cash received in advance of income realization should be initially recorded in a liability account such as "Unearned Revenue". An adjusting entry later becomes necessary as the revenue is earned. The liability should be reduced and the revenue recorded. 2,500 2,500

Note: Accumulated depreciation is a contra account

> Past exchange of cash Cash Unearned Revenue XXX XXX

> Adjusting entry necessary as revenue is earned Unearned Revenue sheet) Revenue statement) XXX (Balance

XXX (Income

Example: Adams CPA previously received $500 for bookkeeping services in advance of providing the services. Adams has now earned $300 of the money. Unearned Revenue Revenue 300 300

II. Accrual Adjustments An accrual involves a future exchange of cash that must be recorded on the income statement before cash is exchanged. A. Accrued Expenses > Adjusting entry Expense statement) Liability > Future exchange of cash Liability Cash XXX XXX XXX (Income

XXX (Balance sheet)

Example: Interest accrued on a loan at the end of the month is $550. Interest Expense Interest Payable 550 550

B. Accrued Revenues > Adjusting entry Receivable sheet) Revenue statement) > Future exchange of cash Cash Receivable XXX XXX XXX (Balance

XXX (Income

Example: Performed $400 of services for a customer on account. Accounts Receivable Revenue 400 400

Depreciation Calculations
This page illustrates the computation of the straight-line and double-declining balance methods of depreciation using the following example.
Cost of Asset 10,500 Salvage Value 500 Life years 1. Straight-Line Depreciation 5

Note that the straight line calculation considers salvage value up front in the calculation. 10,500 cost - 500 salvage value year ------------------------------5 year life = 2,000 per

Depreciation Book Year Cost Expense Depreciation Value -----------------------------1 10,500 2,000 8,500 2 10,500 2,000 6,500 3 10,500 2,000 4,500 4 10,500 2,000 2,500 5 10,500 2,000 500

Accumulated

-----------2,000 4,000 6,000 8,000 10,000

2.

Double-declining Balance Depreciation

The double-declining balance method ignores salvage value in the initial calculation. However, depreciation expense will be limited if the calculated amount would result in the book value dropping below the salvage value. For example, suppose an asset has a prior book value of $600 and a salvage value of $500. In this case, depreciation expense is limited to the remaining $100 book value in excess of salvage value. Also, each year comparisons are made between the declining balance rate calculations and straight-line depreciation of the remaining book value. A switch to the straight-line calculation is made in the year in which the straight-line calculation exceeds the declining balance rate calculation. > DDB rate = 1/Life x 2 = 1/5 x 2 = 40% > Declining balance rate depreciation = Beginning of period carrying value x DDB rate Calculations ---------------------------------------------------Year DDB Straight-Line ------------------------------------------------

1 - 500)/5 = 2,000 2 - 500)/4 = 1,450 3 - 500)/3 = 1,093 4 - 500)/2 = 884 5 - 500)/1 = 861

10,500 x 40% = 4,200 6,300 x 40% = 2,520 3,780 x 40% = 1,512 2,268 x 40% = 1,361 x 40% = 907 544

(10,500 ( 6,300 ( 3,780 ( 2,268 ( 1,361

Note: Switch to straight-line in year 5 since its calculation exceeds the DDB calculation. Depreciation Book Year Cost Expense Depreciation Value -----------------------------1 10,500 4,200 6,300 2 10,500 2,520 3,780 3 10,500 1,512 2,268 4 10,500 907 1,361 5 10,500 861 500 Accumulated

-----------4,200 6,720 8,232 9,139 10,000