What is Deferred Payment: Definition, Examples and How to Use It
Raising enough capital to sustain a firm’s operations can be difficult. Although banks and financial institutions can provide financial backing, the cost of renting capital is high. The hefty interest rate sets you back, although you manage to get a loan. Instead of paying right then, you make your liability a deferred payment and pay later.
Read on to understand what deferred payment is and determine if it is suitable for you.
What Is a Deferred Payment Option?
The term essentially is multi-faceted, although an option to defer payments implies your right to postpone a payment, thereby buying time. In the investment and options market, deferred payment means an exotic option where you can operationally delay payments and ease your liability over time.
Deferred payment options are also applicable for loans, mortgages, insurance and court proceedings. Many retirement plans also offer this option to enable senior citizens to ease their payment structure. They can defer their tax deductions until retirement from when they can avail themselves of senior citizen tax benefits.
How Deferred Payment Works in Options Trading?
In the options market, traders can scramble the liquidity of their payments by deferring payments. The complex structuring of deferred payments increases their importance. This implies that the investor can postpone his/her premium payment until an expiration date.
The options trading scenario considers deferred payments as a long-term investment with stipulated expiration dates on contracts.
What Is Deferred Payment in Exotic Options Trading?
The derivative option contracts offer different payment structures, expiration dates and strike prices. Investors can tweak these contracts according to their hunger for risk and reward expectations. However, unlike regular options, they do not guarantee returns despite their ease of usage.
Traditional options simply give investors a choice to buy or sell their assets at a fixed price on or before the expiration date. They can use call options to buy and put options to sell their asset. On the other hand, exotic options differ from traditional ones in their ability to defer payments in the over-the-counter markets.
Exotic options also apply deferred payments to trading commodities like oil, lumber, equities or foreign exchange. Moreover, exotic options cater to customer-specific risk management needs.
Here is an example to help you understand deferred payments better-
Imagine a music studio collaborating with a foreign musician for a project. As the owner, you have calculated the total cost of all equipment to be around Rs. 10,00,000. However, a shortage of immediate capital limits your possibility.
Instead of scraping off the deal, you partner with a music equipment dealer who agrees to supply your equipment with an option to pay later. Therefore, you pay a small down payment of Rs. 50,000 and get all the receivables immediately. The dealer agrees to accept the balance amount in 10 installments one month after the delivery. Thus, you have deferred your payment.
Loans can also indicate deferred payments if the creditor allows it. Owing to the hardships faced by students in paying student loans, creditors normally defer their payments at a mutually agreed date after their graduation. Small business enterprises can also defer payments for loans offered by the government to compensate for losses accrued due to initiating a government project.
What Are the Types of Deferred Payments?
There are primarily two types of deferred payments: deferred revenue and deferred expense. They have been discussed below in detail:
- Deferred Revenue: It is the money that is received in advance but not yet paid. Examples include prepayments of monthly rent or insurance premiums.
- Deferred Expense: It is the money that is recorded in the balance sheet only when the service has been provided. Examples include fees paid to a lawyer in advance.
You receive deferred revenue receipts before actually selling a good or service, while the deferred expense is incurred later.
What Are Payment Deferrals on Invoices?
You can also defer payments on an invoice to a later date. Simply put, payment deferrals on invoices to a later date benefit both clients and vendors alike. While vendors can add an indication of deferring payments to obtain tax benefits, clients can also defer payments and receive the product or service immediately.
How to Account for Deferred Payments?
From a vendor or creditor’s perspective, deferred payments fall into the accrued revenue category. Accrued revenue is the deferred payment for which the vendor/creditor has already supplied the good or disbursed a loan.
Accounting for deferred payments in double-entry bookkeeping is easy. Against a particular date, the vendor debits the accrued revenue and credits their revenue account. When the customer pays for the good, the vendor will debit their revenue account and credit the accrued revenue.
Deferred payments aim to temporarily provide relief against a loan payment. You can also defer your credit card bills if your bank provisions it. In short, deferred payments aid defaulters in times of financial emergencies.