A deferred asset refers to expenditures that have been made in the current period but will not be charged against income until a later period. Essentially, it is a prepaid expense that will be recognized as an expense over time as the benefit is received. It is also known as a prepaid asset.
Deferred assets are considered current assets on the balance sheet because the benefit is expected to be realized within one year of the balance sheet date. If the benefit extends beyond one year, it may be classified as a long-term asset, or non-current asset, depending on the nature of the expenditure.
For example, if a company pays in advance for two years’ worth of insurance premiums, the amount paid would be recorded as a deferred asset. Over the two years, the company would gradually recognize the insurance expense on its income statement, and the amount of the deferred asset on its balance sheet would correspondingly decrease.
Deferred assets are subject to periodic evaluation for potential impairment. If the future benefit of a deferred asset is not likely to be realized, it should be written off and recognized as an expense immediately.
Example of a Deferred Asset
Let’s take an example of an insurance premium, which is a common type of deferred asset.
Suppose a company pays an insurance premium of $12,000 in January for a policy that covers the entire year. The company would initially record the entire $12,000 as a deferred asset (also known as a prepaid expense) on its balance sheet. This reflects that the company has paid for a service (insurance coverage) that it will receive over the next 12 months.
Each month, the company would recognize $1,000 ($12,000 / 12 months) of the insurance expense on its income statement, reflecting the cost of the insurance coverage for that month. At the same time, it would reduce the deferred asset on its balance sheet by $1,000. By the end of the year, the entire $12,000 insurance expense would have been recognized, and the deferred asset would be zero, reflecting that all the insurance coverage has been used.
Here’s what the monthly journal entries would look like:
- Debit (Decrease) Prepaid Insurance (Deferred Asset): $1,000
- Credit (Increase) Insurance Expense: $1,000
These entries ensure that the company’s financial statements accurately reflect the timing and amount of its insurance expense, in accordance with the accrual basis of accounting and the matching principle.