When using accrual accounting in your business, the issues of deferred and accrued expenses must be addressed. Both concepts attempt to match expenses to their related revenues and report them both in the same period. If using the cash basis of accounting, all expenses are recorded when money changes hands, not when the expense is incurred, so there are no deferred or accrued expenses for which to account.
Generally Accepted Accounting Principles
Generally accepted accounting principles (GAAP) are a collection of rules for measuring, valuing and accounting for financial transactions in a company. These standardized rules allow companies to be compared to one another and evaluated on the same basis. One of the most important underlying premises in GAAP is the matching of revenues and expenses in the period incurred. For example, if you are a manufacturer and your company spends money building inventory this year but won't sell it until next year, your current year financial statements will show a large expense and next year's will show a large income. Matching will push (or defer) the expense until the product sells and has revenues to match it. Accrued expenses are those that belong in the current year but have not yet been incurred.
Period expenses are those that belong in the current period and are never accrued or deferred. They are not related to specific operations but instead to the whole operation. Examples of period expenses include advertising, marketing, sales and administration salaries and rent. Period expenses are expensed when incurred, because they cannot be traced to any particular product or service.
Deferred expenses are those that have already been paid but more properly belong in a future period. Without deferral, these expenses would be recorded on the income statement and would reduce net income in the current period. Deferring them takes them out of expenses and creates an asset on the balance sheet. This type of expense represents an asset, because the money has already been spent and there will be a benefit to the company in the future. When the benefit has been realized, it is taken out of assets and once again expensed. Examples of deferred expenses include prepaid rent, annual insurance premiums and loan negotiation fees.
Accrued expenses are the opposite of deferred expenses. They are expenses that belong in the current period but have not yet been billed to the business. Because the related revenues are recognized in the current period, these expenses also need to be brought forward. This is done by estimating the amount of the expense and recording it in the current period. An offsetting liability is set up on the balance sheet that will disappear once the expense has been paid. Examples of accrued expenses include accounting and tax fees for year-end work and utilities.
Angie Mohr is a syndicated finance columnist who has been writing professionally since 1987. She is the author of the bestselling "Numbers 101 for Small Business" books and "Piggy Banks to Paychecks: Helping Kids Understand the Value of a Dollar." She is a chartered accountant, certified management accountant and certified public accountant with a Bachelor of Arts in economics from Wilfrid Laurier University.