Accounting Principles – Deferred Expense

Rather more stress should be laid on the nature of these items and their significance than the name by which they are designated. If we are to be precise we shall probably call them deferred charges to expense, since this term seems most accurately to describe them. They are expense items wherein the act of charging them to expense accounts, which accounts will be in turn closed out to profit and loss has been deferred to a subsequent period giving to them the effect of assets. This group comprises insurance, taxes, rent, advertising, organization expense, development expense, moving expense, etc.

It is quite usual to look upon these items as in the nature of prepaid expenses. They may be prepaid in many cases. However, it should be pointed out that the matter of prepayment does not enter into the proposition. They are to be considered as assets if the corresponding liability has been taken up whether or not it has been paid. There is no uniform rule for handling them, neither is there any uniform rule for writing them off. In some instances such as insurance, taxes, rent and advertising, the period which they cover is defined. In other cases such as organization and development expenses the period covered is undefined and must be arbitrarily fixed. They are usually prorated over a period of time, but there are cases where their valuation is governed by circumstances such as whether the concern in question is a going concern or one about to be wound up.

There are two ways of handling deferred charges to expense. One is to provide in each case two accounts, one for assets and one for the expenses, and sometimes a third account for the reserve. At the time of closing the books the asset account is either written down to the expense account or the expense account charged and the reserve account credited. The other method consists in treating them as the expense accounts. At closing time the balance of the unexpired assets is treated as an inventory and applied to the expense account thereby converting it into an asset through the inventory, which is brought down while the balance in the account is closed out to profit and loss. The first named method is the clearer of the two and is to be preferred. It is clean cut at all times and greatly facilitates efficient work.

With regard to insurance the amount shown as the asset is the premium on the policy. It matters not whether the premium has been paid so long as the invoices for same have been received and the amount is included among the liabilities. Here the period covered is defined by the policy. It may be for three years, or for one year or a shorter period of time. Arrangements should be made to write off the premium over the life of the policy charging to each period’s operations or expenses its prorata share. For example, if on January 1st a company insures some of its property and the premium on the policy is $1,200, there should be charged off to expense each month $100. It is not customary in the case of insurance to create a reserve. The preferable method is to charge expense or insurance and credit insurance premiums or unexpired insurance as the title of the account appears.

The procedure is comparatively simple in the ideal case just mentioned. It would ^become somewhat more complex when there are a great many policies in force covering different periods and maturing at different dates. There is not much help for this complication if the company closes its books monthly, quarterly or semi-annually, but it may be avoided if the books are closed but once a year by arranging to have policies written for one year or fractions thereof and having them all expire, for example, on the 31st of December. This last mentioned practice is somewhat helpful even when policies are written for periods greater than a year.

In many concerns the question of insurance is of sufficient importance and the policies so numerous as to warrant the keeping of an insurance register wherein the policies are entered with their descriptions and columns are provided so that the amount of the premium can be prorated and the amount corresponding to each month shown in the appropriate column. Thus it ‘becomes possible to determine by footing up the various columns the amount for all premiums chargeable to expense each month. Care must be exercised in this as in other cases to see that cancellation and return premiums are properly prorated and deducted. This is very often accomplished by using red ink and making the entries either above or below the original entries.
The question of cancellation brings to mind the basis upon which such cancellations are made. A premium of $1,200 covering insurance for a year, if cancelled at the end of six months will not result in a refund of $600, although such would seem reasonable. The insurance company considers that it is entitled to a higher premium for carrying a policy six months than for carrying it a year. Accordingly if a policy as above mentioned were cancelled at the end of six months the company would only allow what is termed the short rate, and which in the case of the policy in question would be $360. Short rate tables are issued by the National Board of Fire Underwriters and show the short rates on amounts from $1.00 to $1,000 for periods up to twelve months.

The question may be asked after the above statements, “Is it proper and consistent to carry the unexpired insurance on the pro-rata basis?” The point is perhaps debatable. If it is true that after one-half the period covered by the premium has expired and the company will not return the other one-half if the policy is cancelled, then the unexpired proportion would seem not to be worth one-half of the amount paid, but a somewhat smaller amount. In order to substantiate this valuation it is necessary to introduce the everlasting hypothetical question, “what would the policy be worth if the company were to cancel it?” Were the “if” in this case to be considered the policy should undoubtedly be valued on a short rate basis. In view of the fact that the company expects to use the insurance and not cancel the policy, the expense of the policy will be proportionately less on account of the long time and the unexpired proportion worth more. Practice dictates the use of the latter method.

There is one expection to the foregoing rule of which cognizance should be taken. It will be noticed that mention was made of the fact in the preceding paragraph that the company expected to make use of the insurance, which reason was given for justifying the prorating of the premium. Where a concern is in bankruptcy or about to go into liquidation or any situation arises in which the unexpired insurance will not be used, then the unexpired proportion might very properly be valued on the short rate basis.
The amount of premiums paid by companies carrying large amounts of insurance becomes so great at times as to warrant their taking the risk themselves and instead of paying the premiums to the insurance companies depositing them in a fund out of the accumulations of which any replacements of property destroyed by fire may be made. This has the effect of carrying the risk instead of placing it upon an insurance company and is often practicable where the possibility of destruction through fire is small. It means many times a saving of money to the company and the procedure may be a highly successful one. There is always the danger, however, of a conflagration, in which case it will be wished with regret that the property had been insured in a company able to stand the loss.

There is not much to be said concerning taxes and rent. They are understood to be items either paid in advance or the liability for which has been acknowledged. They should be written down over the period which they cover. «Care should be taken in the case of taxes to observe the effect which the tax bill has, at the time of its receipt, upon the expense and accrual accounts.

Assuming a tax bill for the year ended December 31st amounting to $600 to have been received on the 15th of October and to have been entered in the voucher register but to be unpaid at October 31st. If the taxes had been accrued monthly on the basis of $600, upon closing the books at October 31st there would have been charged to the expense account for taxes $500 and a credit in an equal amount made in the taxes accrued. The question may now be asked, how should the tax bill be treated in the books at October 31st? Taxes for the year are due the first week in October, therefore if the bill is taken up for the full amount, taxes for two months, will at October 31st, have been for all practical purposes prepaid. Without question the liability will be $600, and the prepaid proportion will amount to $100. If the bill for $600 were to be charged to taxes paid in advance and credited to accounts payable there would be a double liability by virtue of the fact that $500 had already been accrued. To prevent this possibility when the credit for $600 was made to accounts payable the charge should be divided; $500 should be charged to taxes accrued and $100 to taxes paid in advance. Subsequent to October 31st the account for taxes paid in advance should be written down to taxes in equal monthly installments.

Advertising is somewhat different from the above mentioned items. The question to be decided and which bears on the writing down of the asset seems to be rather the rapidity with which the advertising is used than the period covered. A concern which paid for advertising in advance to the extent of $96 would be justified in carrying that amount as an asset until the advertising was used, the fact that a year was the period covered by the contract would have no bearing on the matter. It is true that the copy might be spread over a year in twelve numbers, in which case one-twelfth of the amount paid would be written off monthly. If, on the other hand, the $96 was for one page of space there would be no reason why the amount should be written off except as space up to one page was used. In any of these cases the entry would consist in charging advertising expense and crediting advertising prepaid.

Organization expense and development expense are of much the same nature. A pile of bricks lying by the side of the road has not much significance. If an architect draws plans for a house and the bricks through the application of careful planning and labor are worked into a house, there will not be much question about the propriety of charging to the cost of the house the fee that is paid to the architect for preparing the plans and supervising the work of construction. Neither will the expense of directing the labor, organizing and superintending the work of construction be objected to as not properly included in the cost. All of these items have added to the value of the bricks. As component parts none of the elements were worth as much as when they became organized into a structure.

Consequently there is no more reason why the expense of organizing a corporation or any other company should be objected to as not adding value to the organization. The benefits to be derived from the organization of a corporation extend over a period of years. The benefits do not inure entirely to the first year. It may almost be said that they extend over the life of a charter in the case of a corporation. There is no fixed rule as to the extent, nor is there any fixed rule as to the term of years over which they should be spread. Ultra-conservative corporations where the profits immediately after organization are large, charge them off against the first year’s profits in order to be rid of them. Other organizations spread them over a period of five years; some over ten years and some even as long as twenty years. It is probable that ten years is the average. Organization expenses will consist of various items, such as compensation and expenses of officers or stockholders prior to incorporation; legal and other expenses incident to the organization. The account sometimes includes the bonus paid to promoters. The amount as ultimately determined should be written down over the term fixed by the officers or directors, by charging organization expense written off and crediting organization expense. The same thing can be accomplished by charging organization expense written off and crediting reserve for organization expense. The latter is perhaps to be chosen because of the fact that it permits the original asset to stand, thus showing at all times what the expense of such organization was. When the reserve equals the asset one may be closed out against the other if desired.

Development expense is usually found in connection with mining companies where it is treated in a manner similar to that described above in connection with organization expense.

Moving expense is sometimes found as a deferred charge. This may happen where it becomes advisable for a plant to move from one place to another and it is thought that the benefits resulting from the change of location are sufficiently great to warrant the expense thereof being charged to a deferred account. It is thought few concerns will be found which capitalize this item, for the reason that they are less justified in deferring the charge on an expense of this kind than in almost any other case imaginable.