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DEFFERRED CHARGES

What is Deferred Charge


A deferred charge is a long-term prepaid expense that is carried as an asset on a
balance sheet until used/consumed. Thereafter, it is classified as an expense
within the current accounting period. Deferred charges often stem from a
business making payments for goods and services it has not yet received, such
as prepaid insurance premiums or rent.

BREAKING DOWN Deferred Charge


There are two systems of accounting: cash basis and accrual basis. Cash
accounting, most commonly used by small businesses, records revenues and
expenses when payments are received or paid out. Accrual accounting records
revenues and expenses as they are incurred regardless of when cash is
exchanged. If the revenue or expense is not incurred in the period when
cash/payment is exchanged, it is booked as deferred revenue or deferred
charges. The accrual method is required for businesses with sales exceeding $5
million per year or with inventories available to the public and gross receipts
exceeding $1 million per year.

Deferred Charge Example


To receive a discount, some companies pay their rent in advance. This advanced
payment is recorded as a deferred charge on the balance sheet and is
considered to be an asset until fully expensed. Each month, the company
recognizes a portion of the prepaid rent as an expense on the financial
statements. Also, each month, another entry is made to move cash from the
deferred charge on the balance sheet to the rental expense on the income
statement.

A deferred charge is the equivalent of a long-term prepaid expense, which is an


expenditure paid for an underlying asset that will be consumed in future periods,
usually a few months. Prepaid expenses are a current account, whereas deferred
charges are a non-current account.

Deferred Charge Vs. Deferred Revenue


Recording deferred charges ensures that a company's accounting practices are
in accordance with generally accepted accounting principles (GAAP) by matching
revenues with expenses each month. A company may capitalize the underwriting
fees on a corporate bond issue as a deferred charge, subsequently amortizing
the fees over the life of the bond issue.

Deferred revenue, on the other hand, refers to money the company has received
as payment before a product or service has been delivered. For example, a
tenant who pays rent a year in advance may have a happy landlord, but that
landlord must account for the rental revenue over the life of the rental agreement,
not in one lump sum. Each month, the landlord uses a portion of the funds from
deferred revenue and recognizes this portion as revenue in the financial
statements. As is the case with deferred charges, deferred revenue ensures that
revenues for the month are matched with the expenses incurred for that month.

Deferred Expenses vs. Prepaid Expenses: An Overview


Companies have the opportunity 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.

Deferred Expenses
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.

Common deferred expenses may include startup costs, the purchase of a new
plant or facility, relocation costs, and advertising expenses.
Prepaid Expenses
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.

Key Differences
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.

KEY TAKEWAYS
Definition of Deferred Expense and Prepaid Expense
Deferred expense and prepaid expense both refer to a payment that was made, but due to the
matching principle, the amount will not become an expense until one or more future accounting
periods. Most of these payments will be recorded as assets until the appropriate future period or
periods. Sometimes these amounts are referred to as prepayments.

Before a balance sheet is prepared, the accountant must review the deferrals/prepaids and move
the appropriate amounts to expense.

Difference between Deferred Expense and Prepaid Expense


It appears that most accountants refer to the deferrals that will become expenses within one year of
the balance sheet as prepaid expenses. The amount that has not been expensed as of the balance
sheet date will be reported as a current asset.
The deferred expenses that will not become expenses within one year of the date of the balance
sheet will be reported in the long-term asset section of the balance sheet under the classification
of other assets. (An exception is the costs of issuing long-term bonds. This amount is reported on the
balance sheet as a contra liability account along with Bonds Payable in the long-term liability
section.)

A deferred charge is a cost that has been paid for in the present, but it will be spread
over a long period and be accounted for at a future date. Deferred charges may
include professional fees and the amortization cost (lose of value) of intangible assets,
such as copyrights and research and development. Prepaid expenses, on the other
hand, are costs that the business pays in advance prior to when the costs are actually
incurred. Prepaid expenses may include items such as rent, interest, supplies and
insurance premiums. Deferred charges and prepaid expenses are different in various
ways and these differences should always be considered when accounting for them.

Time-Frame Differences

Prepaid expenses relate to a specific time frame, that is, the prepaid transactions must
occur within a year. For example, the expense transaction for prepaid rent lasts for a
period of 12 months. Deferred charges, on the other hand, have a longer transaction
time frame that exceeds one year over which they are spread through gradual
charges. Interest on long-term loan, for example, is spread over the repayment period
of the loans that may be spread over a period of 10 years.

Occurrence Differences

Prepaid expenses occur on a predetermined routine basis, such that the business
requires to consume these expense items continuously to facilitate the different
functions and activities. For example, the rent and insurance premiums occur regularly
and these expense items are extremely necessary in facilitating the activities of the
business. Deferred charges, on the other hand, do not occur frequently because they
are linked to the strategic plans of the business that are spread over a long period of
time. For example, professional fees are incurred on rare occasions.