What are Prepaid Expenses? – Definition, Examples, and Journal Entry

Prepaid expenses represent payments made in advance for products or services expected to be incurred at a later date. They denote a benefit that is due to the company in the future. 

This article helps understand the uses, examples and benefits of prepaid expenses, how to record them, and their impact on financial statements. Read on! 

What are Prepaid Expenses?

When a company or business makes a payment in advance for an expense that has not yet been utilised in the current financial period, it is called a prepaid expense. Such expenses are accounted for as an asset in the accounting books. Later, these are recorded as expenses when their benefits are utilised.

Prepaid expenses are used to purchase goods or services that are to be received in future; this frees up capital for other expenses. 

How Do Prepaid Expenses Work?

Prepaid expenses refer to payments made by a business for goods or services that will be consumed in the future. Essentially, a business pays upfront for a good or service, and the benefit is received over time. Examples of prepaid expenses include insurance premiums, rent, or subscription services.

Prepaid expenses are treated as assets on a company’s balance sheet, as they represent future economic benefits. The expense is then gradually recognised over the period it is consumed, through an adjusting entry. This means that the expense is spread out over time, rather than being recognised all at once.

Overall, prepaid expenses are an important accounting concept that helps businesses to better manage their cash flow and accurately reflect the value of goods and services received over time.

Why are Prepaid Expenses Assets?

Prepaid expenses are considered assets for a business because they represent future economic benefits. When a business pays for goods or services in advance, it expects to receive the benefits of those goods or services over a period of time. For example, if a business pays for a year’s worth of insurance premiums upfront, it expects to receive the benefits of that insurance coverage over the course of the year.

By treating prepaid expenses as assets, businesses can accurately reflect the value of future economic benefits on their balance sheet. This is important for financial reporting and analysis, as it provides a more accurate picture of a company’s financial health and future cash flows.

How are Prepaid Expenses Recorded?

Prepaid expenses are recorded as current assets in a company’s balance sheet when a payment is made. For example, let’s say a journal entry is recorded as amount X paid for ABC Prepaid Expense; amount X is the cash credit.

Within a financial year, each time a portion of the expense is paid off, the prepaid account is gradually debited until the value becomes zero. Then, once the value of the asset gets completely utilised, the expense is shifted from the current asset account and is recorded as an expense. 

As per the Generally Accepted Accounting Principles (GAAP), advance payments cannot be credited to the expense account immediately. Hence, prepaid expense accounts are useful for recording future assets. 

Also Read

Accrued Interest – Definition, Example & How to Calculate it?

Net Interest Income (NII) – What is It and How is It Calculated?

Examples of Prepaid Expenses

Usually, expenses recorded as prepaid expenses by organisations are for advance rent payments, insurance payments and other recurring expenses commonly paid in advance. In addition, taxes, leased equipment, etc., are also deemed prepaid expenses.

To practically understand the application of prepaid expense, we can follow the example given below:

Let’s say XYZ Logistics has leased a new warehouse in Delhi. The monthly lease agreement value is ₹15,000. According to the terms and conditions, the current year’s full rent must be paid in advance, which is ₹1,80,000. 

The prepaid expenses journal entry could be something like this:

In the following month, the rent for January will be deducted from this account. The journal entry would be:

The same journal will repeat for each month till December, when the balance in the prepaid rent account will be zero.

The outward rent payment for each month will not be a cash transaction but only a record of accounts in the books. This is the purpose and benefit of prepaid expenses in the balance sheet.

What are the Uses of Prepaid Expenses?

The reason prepaid expenses exist is because of the rules of accounting. Generally, the expenses of a company are to be recorded in the same accounting period as when the benefits of an asset are utilised. 

Prepaid expenses reflect the cost of assets whose benefits will be realised later during future accounting periods. Each time the asset gets used for its value, a portion of its cost also gets deducted from the total cost that was first denoted in the books. Hence, prepaid expenses help to reflect costs of assets accurately in the company’s financial statements. 

Are Prepaid Expenses Debits or Credits?

From the perspective of a business, the initial transaction of cash to a prepaid account is a debit expense between two current accounts. As these accounts are both asset accounts, they do not increase or decrease any value on the balance sheet.

When the expense is utilised at once or systematically, the transaction is debited from the prepaid expense account and credited to a particular expense account.

What is Prepaid Expense Amortization?

Prepaid expense amortization is the process of gradually recognising the expense of a prepaid asset over the period it is consumed. When a business pays for goods or services in advance, such as rent or insurance, the payment is initially recorded as a prepaid expense.

To recognise the expense over time, the prepaid asset is gradually amortized through an adjusting entry. This means that a portion of the prepaid expense is recorded as an expense on the income statement each accounting period until the full amount of the prepaid asset has been consumed.

Prepaid expense amortization is important for accurate financial reporting and ensures that the expense of the prepaid asset is recognized in the appropriate period, rather than all at once.

What are the Advantages of Prepaid Expenses?

Prepaid expense helps to record transactions and organise expenses that are due in the future. This account benefits a business in several ways:

1. Saves Money

As the payment is a transaction between two asset accounts, there’s no cash outflow in the accounts. Hence, till the expenses are debited, the money is available with the company. This helps businesses plan and budget future expenses accordingly and save money in accounting.

2. Saves Tax

Prepaid expenses help businesses defer taxes to a later financial year. As per the rules of accounting, expenses can only be recorded when they are incurred. Hence, tax on an advance expense can only be deducted in the year to which it applies. 

3. Tracking and Recording

Expenses that are made for future assets always pose a threat of not getting utilised. For example, let’s say a rental agreement is violated, and the landlord terminates the remaining tenure. One can easily track this during a period of accounting if there’s a prepaid account to reflect this expense.  

Where Do Prepaid Expenses Appear on the Balance Sheet?

Prepaid expenses appear on a business’s balance sheet as current assets unless they will not be incurred within 12 months. As the prepaid expense is consumed, the amount recognised as an asset on the balance sheet decreases and the amount recognised as an expense on the income statement increases.

What is the Effect of Prepaid Expenses on Financial Statements?

As explained above, the prepaid expense initial entry does not affect the financial statements as it is a transaction between two asset accounts. A prepaid expense account, which is an asset, offers financial advantages only at a later date.

However, the future entries for the prepaid expenses when the expense is debited affect the income statement and balance sheet – there is an increase in the expense account and a decrease in the assets account. 

Prepaid Expenses vs Accrued Expenses

The differences between the two types of expenses in accounting have been discussed below: 

Final Word

Prepaid Expenses are productive to a company’s accounting records, and it is crucial to understand their application in a financial statement. They help to track cash flow, organise expenses and save taxes. However, this expense is not similar to accrued expenses as the latter is a liability, and the prepaid expenses are assets.

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