Prepaid Expenses

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 sheet, 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 prepayment expenses.

• 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 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) mandates the recording of expenses in the fiscal year 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.

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:

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

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. 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 statement.

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.  

Following is a list of prepaid payments in accounting:

• Prepaid rent of commercial premises
• Prepaid salary
• Prepaid taxes
• Prepaid electricity bills
• Prepaid telephone bills
• Prepaid interest
• Prepaid insurance

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 expenses —pertaining to the upcoming year, 2022. On January 01, 2022, the insurance expense was recognized. Now, document the relevant prepaid expense journal entries into the books of XYZ Ltd. 

Solution:

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

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:

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 -

• Deferred Expenses Meaning
• What is Accrued Revenue?
• Unrealized Gains (Losses) | Explanation
• Off-Balance Sheet Financing