What is a prepaid asset
What is a deferred asset?
A deferred asset is an expenditure that is made in advance, and is not yet consumed. It arises from one of two situations:
- Short consumption period. The expenditure is made in advance, and the item purchased is expected to be consumed within a few months. This deferred asset is recorded as a prepaid expense, so it initially appears in the balance sheet as a current asset.
- Long consumption period. The expenditure is made in advance, and the item purchased is not expected to be fully consumed until a large number of reporting periods have passed. In this case, the deferred asset is more likely to be recorded as a long-term asset in the balance sheet.
Examples of expenditures that are routinely treated as deferred assets are:
- Prepaid insurance
- Prepaid rent
- Prepaid advertising
- Bond issuance costs
The reason for treating expenditures as deferred assets is that they would otherwise be charged to expense before the related benefits had been consumed, resulting in inordinately high expense
recognition in earlier accounting periods, and excessively low expense recognition in later periods.
The deferred asset concept is not applied when a business uses the cash basis of accounting, since expenditures are recorded as expenses as soon as they are paid for under that method. Thus, these items would be charged to expense at once under the cash basis of accounting.
It is easy to forget about deferred asset items that are sitting on the balance sheet, which means that there tends to be a large write-off of these items at year end, when accounts are being examined by the auditors. To avoid this potentially large write-off, track all deferred asset items on a spreadsheet, reconcile the amounts on the spreadsheet to the account balance listed in the general ledger at the end of each accounting period, and adjust the account balance (usually with a periodic charge to expense) or spreadsheet as necessary.
To avoid the labor associated with tracking deferred assets, consider adopting an accounting policy under which expenditures falling beneath a minimum amount are automatically charged to expense.
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