The world of accounting has some interesting standards and rules. The common question arises early on: “What is a prepaid expense?” and as a follow up, “What is the right way to deal with/ record the amortization of prepaid expenses?”
Here, we will cover the definition of prepaid expenses, how to properly record them, and how automated financial software can manage the nuances for you.
Coming Up
2. What is the Purpose of a Prepaid Expense?
3. What are Examples of Prepaid Expenses?
4. What is Prepaid Expense Amortization?
5. Are Prepaid Expenses a Credit or Debit?
6. What is the Effect of Prepaid Expenses on Financial Statements?
7. Why Can't Prepaid Expenses be Deducted Straight Away?
8. Does it Make Sense to Prepay and Expense?
9. What is Prepaid Expense vs Accrued Expense?
What is a Prepaid Expense?
A prepaid expense refers to future expenses that are paid in advance. The prepaid expense begins as an asset on the balance sheet. Then, over time, as the asset provides its value, it gets recorded as an expense (on the income statement) during the same accounting period as when the asset delivers its value.
So, as the benefits of the expense are recognised, the asset’s value decreases in the form of an expense.
For example, if your company buys a large and expensive photocopier that it plans to use over time, it could be considered a prepaid expense. That is, the photocopier will provide benefits to the company over its lifetime, not just when it is purchased, so it should be listed as an expense over the time period it does so.
What is the Purpose of a Prepaid Expense?
The reason that prepaid expenses exist is because of accounting methods. To exemplify, the generally accepted accounting principles (GAAP) notes that expenses are to be recorded in the same accounting period as when the asset delivers its benefits.
For certain expenses, this is the case, so there has to be a process related to how to properly record them in the company’s books. Prepaid expenses begin on the balance sheet as an asset.
Even though the cost of the asset (expense) has been made already, it isn’t yet an expense in the financial records. They transform into an expense during a later accounting period (when the asset gets used for its value).
When the benefits are realized over time for such assets, then they get recorded as an expense in each related accounting period on the income statement. At each time that a portion of the expense is allocated, then it’s also deducted from the total cost that was first denoted in the asset account.
Again, the purpose of these prepaid expenses is so that the company’s financial statements are accurately reflected when the cost of the expense is providing the related benefit (so everything will be balanced).
What are Examples of Prepaid Expenses?
There are several different examples of prepaid expenses. Depending on your line of business, you may have some or several.
Here’s a look at some prepaid expenses examples:
- Prepaid rent
- Prepaid Insurance
- Taxes
- Interest payments
- Leased office equipment
- Salaries
- Bulk supply orders
- Retainer for legal services
- Employee insurance policies
Here’s how these prepaid expenses look when they get recorded:
- Make the prepaid expense payment
- Enter the payment total in the related asset account
- At first, debit the asset in the account for the paid amount and then subtract that same amount from the cash account (the accounts are balanced, so nothing is affected here because the credit and debit column cancel each other out)
- When each accounting period comes to a close and your company has recognised the benefit of the prepaid expense, then you must expense that portion on the income statement. So, you subtract the period’s cost from the asset account, add the same amount to the cash account, and this will reduce the balance of the prepaid account, making it an expense.
- You rinse and repeat until the prepaid asset has been fully realised. At the end of all the payments, then the account reflecting the asset should be at $0.
As you can see, if you have multiple prepaid expenses, then this process could easily become overwhelming to keep track of and maintain properly.
A financial automation software solution can do the work for you so that you can ensure nothing slips through the cracks. At the end of the asset’s life span, it will zero out (and you won’t have to worry about having made any human errors or having forgotten about a prepaid expense).
What is Prepaid Expense Amortization?
Prepaid expense amortization is the process reflected above in which the asset’s value trends to zero over the time that the prepaid expense is delivering its value to the company.
In simple terms, it's how the consumption of a prepaid expense gets recorded over time. The amount of a common accrual, i.e. rent or insurance, is gradually reduced to zero. The expense moves to the profit and loss statement during the accounting period when the company uses up the accrual.
Are Prepaid Expenses a Credit or Debit?
This topic can be confusing, so if you’re still wondering, “What is a prepaid expense” then understanding how it is defined as a credit and debit over time and on the books could help clear things up.
A prepaid expense is recorded as a credit and a debit, but it is all based on the accounting period and timing. Hence, this is why a financial automation solution is of such great use because you wouldn’t want to forget about a record related to a prepaid expense because it could end up messing up your books.
The payment that reflects a prepaid expense will be debited in the prepaid account and then credited in the cash account. Thus, the balance sheet is balanced. Then, the accounting team will set up the amortization schedule.
After each accounting period, the journal entry is posted that reflects the portion of the expense incurred for that specific period according to the established amortization schedule. The journal entry credits the prepaid asset account (on the balance sheet) and debits the expense account (on the income statement).
The records will reflect that incurred expense for the period, which will reduce the prepaid asset by that amount.
What is the Effect of Prepaid Expenses on Financial Statements?
At first, the company’s financial statements are unaffected by prepaid expenses. This is because the initial journal entry is debited to the related account (i.e. prepaid rent or prepaid insurance) and then credited as cash.
These two asset accounts leave the balance sheet unaffected. But, once the amortization schedule kicks in during each respective accounting period, then the adjusting journal entry will impact the income statement and balance sheet.
The period’s cost of the asset (expense) will be reflected on the income statement as that, an expense. The deduction of that amount will reduce the balance sheet’s assets for the same amount.
Take a moment, again, to consider how automating this process would streamline your accounting team’s time and help to ease the financial close process at the end of each accounting period.
Why Can't Prepaid Expenses be Deducted Straight Away?
Prepaid expenses cannot be deducted as they are paid because it would not be in line with the generally accepted accounting principles (GAAP).
The expense needs to correlate with the accounting period in which it delivers its value. That’s why the amortization schedule is created.
For example, say a company pays prepaid rent for $10,000 a month, so $120,000 a year. The entire $120,000 is the total expense, but the company will only generate revenue associated with the rent during each rental period (or in this case, month). So the asset will decrease in value by $10,000 at the end of each month.
Does it Make Sense to Prepay and Expense?
The upsides and downsides related to prepaying an expense depend on the situation. The biggest downside is that you will be deducting cash for other potential uses in the same time period.
Vendors and suppliers also benefit from the interest-free use of your company’s funds. And lastly, there’s risk involved because what if the supplier doesn’t actually deliver what they promise in the future (but you’ve already paid- i.e. a landlord can terminate your lease).
In some cases, the prepaid expense isn’t an option. However, if it is, your company can try to negotiate a discounted rate as it is being paid upfront. Another reason why prepaid expenses may be beneficial is for the opportunity it provides to companies that may have poor credit. As such, vendors or suppliers agree to still do business with them knowing that they are already being paid.
To help keep track of your prepaid expenses, consider using an automation solution so that nothing slips through the cracks. This way, you can ensure that your financial statements and reports are always complete.
What is Prepaid Expense vs Accrued Expense?
A prepaid expense is not to be confused with an accrued expense. As we’ve covered, a prepaid expense is reported as a current asset on the balance sheet. On the other hand, an accrued expense gets recorded under current liabilities on the balance sheet.
An accrued expense is a cost that the company incurs but has not yet paid at the end of the accounting period. Examples of accrued expenses are: the cost of unused sick days, unpaid and accrued interest payable, utility expenses that get paid in the next month after use, etc.
The Bottom Line
So, now you can completely answer, “What is an accrued expense?” Accrued expenses are common across all lines of business, so you’ve surely come across them or had to deal with them in your business.
Financial automation tools can help to remove any stress that comes along with having to track and remember prepaid expenses over time. This way, you can make sure that your financial statements are always in proper order, so audits will run smoothly and you can decrease any risk associated with making mistakes.
