Understanding Prepaid Expenses: Examples & Journal Entry

What are prepaid expenses?

Prepaid expenses are expenses that have been paid in advance but have not yet been incurred or consumed. They are assets on the balance sheet and represent the amount of money a company has paid for goods or services that it will receive in the future.

These expenses are considered assets because it provides economic value to the business in the future. It is recorded in the prepaid asset section of the balance sheet.

What are the benefits of prepaid expenses?

Here’re some benefits of paying your expenses upfront:

Ensures you don’t miss availing the product/service

If there is any product or service that you cannot afford to miss, then it is better that you pay in advance. For example, the rent you pay for your office building is a prepaid expense. You don’t want to miss getting the space and hence pay the rent amount for a month or quarter in advance.

Avoid rising costs

Prepaid expenses help you lock in a product or service at the current market price. In an inflationary environment, this helps you save on costs. For example, if you believe fuel prices will go up next month, you may want to prepay for fuel to avoid paying extra when the price rises.

Helps in tax deductions

Prepaid expenses help businesses manage their future tax deductions. Businesses cannot deduct the full amount of prepaid expenses in the current financial period but have to defer some amount for the subsequent accounting periods. For example, if a business has paid its office rent for three years, it can make an adjusting entry for a section of the tax deductible for that particular year, and the rest of the amount will be used for tax deductions in the subsequent two years

What are examples of prepaid expenses?

Prepaid expenses are payments made in advance for goods or services yet to be received, but which will be used in the future. Examples of prepaid expenses include prepaid rent, insurance premiums, and annual subscriptions. Prepaid expenses are considered assets on a company’s balance sheet until they are used or expire.

What are the methods of recording prepaid expenses?

Prepaid expenses can be recorded under two methods- asset method and expense method:

Asset method

In this method, the entry of the assets is recorded in advance. Also, an already used portion of the prepaid expense increases the expense amount entry and decreases the total prepaid asset value.

Expense method

In this method also assets are recorded in advance but the portion of the expense value corresponding to the financial period remains unexpired till the end of the period. During the adjustment period, the entry for it is made under the prepaid expense asset section.

How are prepaid expenses recorded in the financial statements?

Prepaid expenses are recorded within the prepaid asset account of the balance sheet because it signifies a benefit that can be availed in the future.

Prepaid expenses are considered current assets because they are expected to be utilized for standard business operations within a year.

As the benefits of the prepaid expenses are availed over time, they are recorded in the income statement. Initially, they are not recorded in the income statement because of the principles set by GAAP (Generally Accepted Accounting Principles), which says that expenses cannot be recorded in the income statement until they are incurred.

Conclusion

Prepaid expenses are the amount that is paid in advance. It includes insurance, rent, subscription, and utility bill payments. Prepaid expenses offer tax benefits as well as help you hedge against inflation. Prepaid expenses also help make sure that you do not miss services/goods such as insurance and supplies when needed.

FAQs

Question: What is the 12-month rule for prepaid expenses?

Answer: The 12-month rule for prepaid expenses allows taxpayers to deduct the prepaid amount in the current year if the asset does not extend beyond the one-year period.

Question: What is prepaid account amortization?

Answer: Prepaid account amortization is an accounting process that calculates the periodic cost of the recurring expense that is paid in advance. Following amortization, the prepaid expense, such as house rent, gradually decreases to zero.

Question: Are prepaid expenses recorded in the income statement?

Answer: As per the principle of GAAP, prepaid expenses are not included in the income statement until they are incurred.

Question: What is the most common prepaid expense?

Answer: The two most common prepaid expenses are insurance and rent.

Question: Is prepaid expense an income?

Answer: No, prepaid expenses are not recorded in the income statement as income as per GAAP since they are yet to be incurred.