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Prepaid Expenses – Its Impact on Financial Statements & Examples
11 November 2022
Accounting tools are essential to forming a financial statement of a company that complies with common standards. In addition, these tools ensure the authenticity of a company’s books at the year’s end. Prepaid expenses represent payments made in advance for products or services expected to be received at a later date. They denote a benefit that is due to the company in the future.
This article helps understand the uses and examples of prepaid expenses, how to record prepaid expenses, benefits and their impact on the financial statements. Read on!
What are Prepaid Expenses?
When an organisation makes a payment in advance for an expense that has not been utilised yet in the current financial period, it is called a prepaid expense. Such expenses are accounted as an asset in the accounting books. Later, these entries are written off 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.
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.
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.
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 Rs.15000. According to the terms and conditions, the current year’s full rent must be paid in advance, which is Rs.1,80,000.
The prepaid expenses journal entry will be:
Prepaid rent account
In the following month, the rent for January will be deducted from this account. The journal entry would be:
Rent (expense) account
Prepaid rent account
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.
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 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:
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.
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.
•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.
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. 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.
The differences between the two types of expenses in accounting have been discussed below:
It is a current asset entry
This is a current liability entry
This is an amount that is paid in advance for an asset not yet utilised
This is an amount yet to be paid for an asset already utilised
Example: rent, insurance premiums, etc.
Example: Bonuses or wages payable, warranty payments, etc.
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.
Q1. Can prepaid expenses be a non-current asset?
Ans: Utilising the assets under the prepaid expenses account is necessary within the first 12 months. However, if the expenses are not debited within a year, the asset gets recorded as a long-term non-current asset.
Q2. How do prepaid expenses affect net income?
Ans: Prepaid expenses decrease the cash flow of a company for the current month; this may affect the payment of current expenses, and this may overall affect the net income.
Q3. What are the two methods of accounting prepaid expenses?
Ans: Prepaid expense is first recorded as an asset and later debited as an expense. Hence, it can be recorded by using the asset method and expense method of accounting.
Q4. What are accrued expenses?
Ans: Expenses that are incurred without any invoicing or documentation in the current accounting period are referred to as accrued expenses. Such expenses become current liabilities on a company’s balance sheet and have to be paid off in future.
Q5. Do prepaid expenses have a credit balance?
Ans: No, prepaid expenses do not have a credit balance.However, these expenses have a debit balance which keeps reducing as the asset gets utilised over the financial year.
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Disclaimer: Mutual Fund investments are subject to market risks, read all scheme-related documents carefully.
This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information, and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
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