Prepaid Expenses

What is Prepaid Expense?

A prepaid expense is a type of expenditure that the companies make in advance for goods or services before getting them or availing the benefits of them. It is the opposite of unpaid expenses in which the company pays for the services and goods at a future date.

In the case of prepaid expense, it is recorded as an asset in the balance sheet. It is an expense in the company’s income statements. The services or goods for which a prepaid expense has been made offer value for an extended amount of time in the future.

For example, a company may pay the rent for its factory building for an entire year at the beginning of the year. In this case, the rent for every month, which is value, is covered for every month of the year. In this way, prepaid expenses cover the payments of a future tenure in the present. The value comes later in the case of prepaid expenses.

Some other examples of prepaid expenses may include −

• Employee insurance benefits

• Taxes

• Additional company-related insurance policies

• Interest expenses on loans

• Leased office equipment

• Employee Salaries

• Payment for bulk orders of supplies

• Retainer paid for legal services.

Who is benefited from prepaid expenses?

Prepaid expenses benefit both companies and individuals.

• In the case of companies, it can save costs of goods and supplies as the payment is made beforehand. Usually, suppliers offer a discount when the payment is made upfront which helps companies to save money in the longer term.

• Prepaid expenses may also help companies save tax in accordance with the statutory compliance with the tax deduction rules that indicate how a company can write them off. Therefore, companies may consider purchasing and accounting effects in the future while choosing prepaid expenses.

• Individuals may also be benefited from prepaid expenses. For example, individuals can calculate and save money for their well-being after retirement. In such cases, they save money in units every month during their work life. So, when the individuals retire they have enough money to live for the rest of life for which they have already paid in advance.

Recording Prepaid Expenses

Initially, companies accounting books and balance sheet records prepaid expenses as assets. This means that although the payment has been made upfront, it is not considered as an expense in the accounting books. The accounting team realizes these expenses in a later accounting period. The most common practice is to record the prepaid expense at a period in which the company realizes them.

When the service for which a prepaid expense has occurred covers several periods, then the company allocates the resources according to each period as they have occurred. This indicates that initially when the prepaid expense is made up front, it may not impact the company’s financial statements as it has not received the services or products. As and when the company experiences the service or gets the goods, then the asset account reduces or expenses.

Example of Prepaid Expense Recording

Say company XYZ acquires an office for lease at Rs 50,000 per month. The owner asks foir an upfront payment of one year. Then XYZ has to make a total payment of Rs 600,000 for the entire year upfront. XYZ initially will record this prepaid expense as a debit in the prepaid rent account and as a credit in the cash account.

After one month, the company received a value of Rs 50,000. So, this is recorded as a rent expense, which is debit, and Rs 50,000 as credit in the prepaid rent account. These values are therefore subtracted from the respective accounts. The company does it for 12 months until it has Rs zero in the rent account.

The following steps may be followed to record prepaid expenses −

Making the payment and marking it as an asset on the balance sheet

The first step is to make the prepaid expense and mark it as an asset on the balance sheet. It must be marked as an asset because the company has to get the benefit in the future and has not received the benefit yet. It should not be marked an asset if the company won’t get the service in the next 12 months.

Enter the payment into an accounting journal

After making the payment, the payment must be recorded in an accounting journal which will show that a payment has been made. For example, if a firm pays Rs 100000 for the rent of the office for the next 12 months, note this in the prepaid rent account of the journal. This starts the beginning of the record that the company has paid for something which it has not received yet.

Debit the asset account

For the first record of the prepaid entry, debit the asset account and subtract the value from the cash account so that the net total is not affected. For example, in the above-mentioned case of paying 100000 as rent, add Rs 100000 to the asset account for the prepaid rent account and subtract it from the cash account which keeps the net total record the same.

Expense a part of it on the income statement

At the end of every accounting period as the company gets the service or goods, expense a portion that the company has used in the income statement. For example, say a company makes a prepaid expense on insurance for which it has to incur a cost of Rs 10,000 per month. The company has paid it upfront for a year at Rs 120,000. You have to subtract Rs 10,000 from the prepaid insurance account each month and add Rs 10,000 to the cash account every month. This will reduce the balance of the prepaid account and turn it into an expenditure.

Repeat the above-mentioned process

The above-mentioned process must be repeated until the company realizes the full amount of prepaid expense. For example, in the above-mentioned insurance case, you may have to do it 12 times so that the complete Rs 120,000 of prepaid expense becomes zero in 12 months until which the insurance is covered by the insurer third party.

Conclusion

It is important to know about prepaid expenses and how to record them because, without efficient accounting practices, organizations may face accounting issues in the long term. Moreover, s these expenses are treated differently, an extra amount of consideration must be put in while managing them. That is why prepaid expenses are so critical to business organizations.

FAQs

Qns 1. What is meant by prepaid expenses?

Ans. A prepaid expense is a type of expenditure that the companies make in advance for goods or services before getting them or availing the benefits of them.

Qns 2. Give two examples of prepaid expenses.

Ans. Two examples of prepaid expenses are prepaid taxes and prepaid salaries.

Qns 3. How is prepaid expense recorded on the balance sheet initially?

Ans. Prepaid expenses are recorded as assets initially because they have not been incurred yet.