Deferred Charge: What it is, How it Works, Example

Will Kenton is an expert on the economy and investing laws and regulations. He previously held senior editorial roles at Investopedia and Kapitall Wire and holds a MA in Economics from The New School for Social Research and Doctor of Philosophy in English literature from NYU.

What Is a 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.

Key Takeaways

• Under the accrual accounting system, a deferred charge occurs if the revenue or expense is not incurred in the same period as when payment is exchanged.
• Recording deferred charges ensure that a company's accounting practices are in accordance with generally accepted accounting principles (GAAP).
• The accrual method is required for businesses if their average annual gross receipts for the 3 preceding tax years is $25 million or more.

How a Deferred Charge Works

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 average annual gross receipts for the 3 preceding tax years of $25 million or more.  

Deferred Charge vs. Deferred Revenue

Recording deferred charges ensure 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.

Example of a Deferred Charge

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.