What are Prepaid Expenses?
Prepaid Expenses are the expenses against which the payment has been done in advance by the company in an accounting period but the same has not been used in the same accounting period and is yet to be recorded by the company in its books of accounts.
In simple terms, these are those expenses that are to be incurred in future but the amount for the same has already been paid in advance. Think of it as expenditure paid in one accounting period, but for which the related asset will not be consumed until a future period.
It is an asset because the expense has already been incurred however the benefits are yet to be realized.
List of Prepaid expense in Accounting
- Rent for a commercial space
- Equipment paid for before use
- Salaries
- Taxes
- Some utility bills
- Interest expenses
Example
The main purpose is to recognize expense on the Profit loss statement when the service or goods have been used, following the accrual principle of accounting.
As we see from above, Starbucks reported a such expense of $358.1 million in 2017 and $347.4 million in 2016.
Let’s now use another example of company ABC to help understand the logic in the financial statement preparation.
- Company ABC purchased an insurance for a total premium of $120,000 for the coverage of next twelve month periods. The insurance company is asking for a down payment of $40,000 and four other equal payments of $20,000, which all together add up to $120,000.
- If ABC does not create such an account, it will be expensing the insurance payments as and when the payments are being made on a cash basis. This will cause the monthly income statement reporting to show irregularities as in the first 4 periods only there would be a total of $120,000 in insurance expense and no insurance expense for the following 8 periods, even though the company is covered for the full twelve periods.
Adapting a prepaid insurance schedule will allow the company to prepare an Income statement which is consistent and accurate as shown below:
- Total premium for the 12 months: $120,000.
- As the coverage is for twelve months which makes the monthly insurance expenses of $10,000.
- Now that we are aware that the monthly insurance coverage is $10,000, we can take $10,000 per month out of the Balance Sheet which we initially created for $120,000 and put it into the Expense account (Insurance Expense) on the Income Statement every month with zero balance under the prepaid expense asset account at the end of year.
Prepaid Expenses Accounting Entry
- It follows the matching principle, which states that revenues in an accounting period need to be matched with the expenses in that same accounting period. The unused portion of a prepaid item provides future economic benefit and thus appears as an asset on the balance sheet.
- Based on this matching principle, it is shown as part of the current asset on the balance sheet until it is expensed. The reason it is shown as part of the current asset and not as a long-term asset is that most such assets are consumed/expensed within a few months of their initial recording period.
- If it were likely to not be consumed within next 12 months it would be classified on the balance sheet as a long-term asset.
- Prepaid expenses in one company’s accounting results is unearned revenues in another company’s accounting statements.
Example #1
A company pays $12,000 in advance for insurance for the upcoming year. The prepaid expense journal entry for the same is
From next period onwards, at the end of each period, the company amortizes the insurance-related account for that period and will charge the complete amount of the prepaid insurance amount to expense by the end of the year with following journal entry per month:
Example #2
C Corp pays advance rent of $100,000 on 31st December 2016 to its landowner towards office rent for the year 2017.
Assuming, C Corp has an accounting year end of 31st December 2016, C Corp will recognize an asset of $100,000 in the financial statements of 2016 to recognize its right to use office space in 2017.
Following accounting entry will be recorded in the books of C Corp in the year 2016:
Following accounting entry will be recorded in the year 2017: This asset will be recognized as an expense in the next accounting year to which the rental expense relates.
Importance
- Saving: One good example is rent where the company paid for next 12 months in advance. In other words, the company will be paying rent at today’s rate regardless of any rent increase in the coming months. This results in potential savings which can be quite a significant factoring inflation in next months.
- Tax deductions: Many businesses prepay some of their future expenses to have additional business deductions. The business owner can use these for tax deductions; however, there are various rules to avail the tax benefits and one of the basic rules is that entity cannot deduct it in the same financial year. Therefore, if the company paid maintenance for your vehicles for five years, the company can only deduct a portion of it this year and not the entire deduction.
Prepaid Expenses as Part of Working Capital Expense
Net working capital for a company equals its current assets (CA) minus its current liabilities (CL). Net working capital changes each accounting period as individual accounts that form CA and CL change period on a periodic basis.
Most companies report prepaid expenses as a current asset on its balance sheet, a change in this account is part of a change in net working capital.
However, if a company records any of such expense that it expects to take longer than 12 months to use in the long-term assets section of the balance sheet than this portion is not included in net working capital calculation.
Prepaid Expenses Video
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