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 the 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.
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For eg:
Source: Prepaid Expenses (wallstreetmojo.com)
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 accountingAccrual Principle Of AccountingAccrual Accounting is an accounting method that instantly records revenues & expenditures after a transaction occurs, irrespective of when the payment is received or made. read more.
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For eg:
Source: Prepaid Expenses (wallstreetmojo.com)
As we see from above, Starbucks reported such an 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 statementFinancial StatementFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels.read more preparation.
- Company ABC purchased insurance for a total premium of $120,000 for the coverage of the 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. It causes 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 statementIncome StatementThe income statement is one of the company's financial reports that summarizes all of the company's revenues and expenses over time in order to determine the company's profit or loss and measure its business activity over time based on user requirements.read more which is consistent and accurate as shown below:
- The total premium for the 12 months: $120,000;
- As the coverage is for twelve months, which makes the monthly insurance expensesInsurance ExpensesInsurance Expense, also called Insurance Premium, is the amount a Company pays to obtain an insurance contract for covering their risk from any unexpected catastrophe. You can calculate it as a fixed percentage of the sum insured & it is paid at a daily pre-specified period. read more 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. We can put it into the Expense account (Insurance Expense) on the Income Statement every month with zero balance under the prepaid expense asset accountAsset AccountAsset Accounts are one of the categories in the General Ledger Accounts holding all the credit & debit details of a Company’s assets. The examples include Short-Term Investments, Prepaid Expenses, Supplies, Land, equipment, furniture & fixtures etc. read more at the end of the year.
Prepaid Expenses Accounting Entry
- It follows the matching principle of accounting, 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 sheetBalance SheetA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company.read more.
- 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 the next 12 months, it would be classified on the balance sheet as a long-term asset.
- Prepaid expenses in one company’s accounting results are unearned revenuesUnearned RevenuesUnearned revenue is the advance payment received by the firm for goods or services that have yet to be delivered. In other words, it comprises the amount received for the goods delivery that will take place at a future date.read more 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 entryPrepaid Expense Journal EntryPrepaid expenses are paid in advance and hence are treated as an asset to the company. The most common prepaid expenses are rent and insurance. These are future expenses which are taken care of in advance, providing future economic benefits.read more for the same is
| Debit | Credit | |
|---|---|---|
| Pre-Paid Expense | 12,000 | |
| Cash | 12,000 |
From the next period onwards, at the end of each period, the company amortizes the insurance-related account for that period. It will charge the complete amount of the prepaid insurancePrepaid InsurancePrepaid Insurance is the unexpired amount of insurance premium paid by the company in an accounting period. This portion of unexpired insurance is an asset and will be shown in the balance sheet of the company.read more amount to expense by the end of the year with the following journal entry per month:
| Debit | Credit | |
|---|---|---|
| Expense-Insurance | 1,000 | |
| Prepaid Expense | 1,000 |
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 entryAccounting EntryAccounting Entry is a summary of all the business transactions in the accounting books, including the debit & credit entry. It has 3 major types, i.e., Transaction Entry, Adjusting Entry, & Closing Entry. read more will be recorded in the books of C Corp in the year 2016:
| Debit | Prepaid Rent | 100,000 |
| Credit | Cash | 100,000 |
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.
| Debit | Rent Expense | 100,000 |
| Credit | Prepaid Rent | 100,000 |
Importance
- Saving: One good example is rent, where the company paid for the 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. It results in potential savings, which can be quite a significant factoring inflation in the 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 capitalNet Working CapitalThe Net Working Capital (NWC) is the difference between the total current assets and total current liabilities. A positive net working capital indicates that a company has a large number of assets, while a negative one indicates that the company has a large number of liabilities.read more for a company equals its current assets (CA)Current Assets (CA)Current assets refer to those short-term assets which can be efficiently utilized for business operations, sold for immediate cash or liquidated within a year. It comprises inventory, cash, cash equivalents, marketable securities, accounts receivable, etc.read more minus its current liabilities (CL)Current Liabilities (CL)Current Liabilities are the payables which are likely to settled within twelve months of reporting. They're usually salaries payable, expense payable, short term loans etc.read more. Net working capital changes each accounting period as individual accounts that form CA and CL change period periodically.
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 capitalChange In Net Working CapitalThe change in net working capital of a firm from one accounting period to the next is referred to as the change in net working capital. It is calculated to ensure that the firm maintains sufficient working capital in each accounting period so that there is no shortage of funds or that funds do not sit idle in the future.read more.
However, if a company records, any 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 the net working capital calculationNet Working Capital CalculationThe change in net working capital of a firm from one accounting period to the next is referred to as the change in net working capital. It is calculated to ensure that the firm maintains sufficient working capital in each accounting period so that there is no shortage of funds or that funds do not sit idle in the future.read more.
Prepaid Expenses Video
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