Prepaid Expenses

Article byWallstreetmojo Team
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

What are Prepaid Expenses in Accounting?

Prepaid expenses refer to advance payments made by a firm whose benefits are acquired in the future. Payment for the goods is made in the current accounting period, but the delivery is received in the upcoming accounting period.

In the firm’s 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, such an expense is shown as an asset. It is an asset because the expense has already been incurred; however, the benefits are yet to be realized. Prepaid salary, rent, taxes, electricity bills, and telephone bills are examples of prepaymentPrepaymentPrepayment refers to paying off an expense or debt obligation before the due date. Often, companies make advance payments for expenses as well as goods and services to shed their financial burden. Advance payments also act as a tool to attain monetary benefits. Examples of prepayment include loan repayment before the due date, prepaid bills, rent, salary, insurance premium, credit card bill, income tax, sales tax, line of credit, etc.read more expenses.

Key Takeaways

  • A prepaid expense is an amount paid in advance for the goods or benefits that are to be received in the upcoming period.
  • The various prepayment expenses disbursed by a firm include paid off rent, insurance, interest, salary, utility bills, and taxes.
  • The prepaymemt expense is primarily shown as a current asset in the balance sheet till its benefit is consumed. After receiving the benefit, the expense is transferred to the relevant expense account and recorded in the company’s income statement
Prepaid-expense

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Understanding Prepaid Expenses in Accounting

Prepaid expenses are computed in scenarios where the payment has been made in advance, but the goods are not used in the same accounting period—yet to be recorded in the company’s books of accounts. In simple terms, these are expenses to be incurred in the future, but the amount has been paid in advance.

Generally Accepted Accounting Principles (GAAP)Generally Accepted Accounting Principles (GAAP)GAAP (Generally Accepted Accounting Principles) are standardized guidelines for accounting and financial reporting.read more mandates the recording of expenses in the fiscal yearFiscal YearFiscal Year (FY) is referred to as a period lasting for twelve months and is used for budgeting, account keeping and all the other financial reporting for industries. Some of the most commonly used Fiscal Years by businesses all over the world are: 1st January to 31st December, 1st April to 31st March, 1st July to 30th June and 1st October to 30th Septemberread more or period in which goods are received—regardless of when the payment was made. So here comes the need for prepaid expenses. It is an account formed to record the prepayment made for the goods obtained in the future.

Many business owners prepay some of their future expenses to avail themselves of advantages like tax deductions. However, businesses are not allowed to adjust the amount in the same financial year. For example, let us assume that a company pays lumpsum vehicle maintenance expenses for five years. In such a scenario, the annual tax deduction would be applicable only up to a portion of the five-year benefit and not the entire amount.

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How to Record Prepaid Expenses?

Prepayment expenses have an important place in a company’s books of accounts. They are not treated like other business expenses.

Prepaid Expense Journal Entries

1. At the time of payment:

DateParticulars Dr Cr
Prepaid Expense A/c… Dr
To Cash A/c

2. At the time of recognizing its benefit or receiving the goods or service:

DateParticulars Dr Cr
Expense A/c… Dr
To Prepaid Expense A/c

Prepaid expenses recorded in one company’s accounting books are unearned revenues for another company’s accounting statements.

Prepaid Expenses in Balance Sheet

According to the matching principle of accounting, until benefits are redeemed, the balance sheet shows prepayments as a part of current assets.Current Assets.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 Usually, the benefits are shown in statements within twelve months of payment.

Also, if a partial benefit is received, only the remaining balance of the prepaid expense appears on the balance sheet. This is because the benefit of the remaining balance is not yet realized. If it were likely not to be consumed within the next 12 months, it would be classified on the balance sheet as a long-term asset.

Prepaid Expenses in Income Statement

The prepaid expense amortization accounts for the prepayments over the period. The prepayment expense that appears on the balance sheet as a current asset is slowly transferred to the respective expense account—when the benefit is realized. This is done with the help of the amortization schedule. Thus, it is documented as an expense on the 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.

If the benefit is derived from a portion of the prepaid expense, then the income statement only reflects the amount for which benefits are received. Therefore, this amount is shown as an expense. Also, the balance sheet shows the remaining balance as a current asset.  

Prepaid Expenses Examples 

Following is a list of prepaid payments in accounting:

Let us now look at practical examples to understand the application of this expense:

Example #1

On July 29, 2021, XYZ Ltd. paid $12,000 in advance for 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—pertaining to the upcoming year, 2022. On January 01, 2022, the insurance expense was recognized. Now, document the relevant prepaid expense journal entriesPrepaid Expense Journal EntriesPrepaid 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 into the books of XYZ Ltd. 

Solution:

Following are the Journal Entries in the books of XYZ Ltd.:

Date ParticularsDr ($) Cr ($)
29/07/21Prepaid Insurance A/c…                       Dr12000
To Cash A/c12000
Date ParticularsDr ($) Cr ($)
01/01/22Insurance A/c…                                      Dr12000
To Prepaid Insurance A/c12000

Example #2

C Corp pays an advance rent of $120,000 on December 31, 2021, to its landlord—for the next twelve months. If the company pays $10000 as rent on the first day of every month, formulate prepaid expense journal entries up to March 2022.

Solution:

Following are the journal entries in the books of C Corp:

Date Particulars Dr ($) Cr ($)
31/12/21Prepaid Rent A/c…                                Dr120000
To Cash A/c120000
DateParticularsDr ($)Cr ($)
01/01/22Rent A/c…                                           Dr10000
To Prepaid Rent A/c10000
01/01/22Rent A/c…                                           Dr10000
To Prepaid Rent A/c10000
01/01/22Rent A/c…                                           Dr10000
To Prepaid Rent A/c10000

Frequently Asked Questions (FAQs)

Is Prepaid Expense an Asset?

It is an assurance that the company will receive a future benefit, goods, or service in lieu of the prepayment made to the vendor. Therefore, such expenditure is recorded as a current asset in the firm’s balance sheet—till the benefits are received.

Are prepaid expenses shown on income statements?

Such expenses are shown on income statements, only when the benefits are realized in the specific accounting period.

What are the examples of prepaid expenses?

Examples of prepayments include prepaid insurance, rent, salary, tax, electricity bill, and telephone bill.

Prepaid Expenses Video

 

This article has been a guide to what is Prepaid Expense & its meaning in accounting. We study prepaid expenses as current assets in journal entries, balance sheets & their amortization along with examples. You may have a look at the articles below to learn more about accounting –