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Key Takeaways
- A prepaid expense is an expense paid in advance but not yet incurred. Some examples of prepaid expenses are prepaid rent, leased office equipment and vehicles, and bulk orders of supplies.
- Prepaid expenses are recorded as assets in the balance sheet as the benefits of the goods or services are gradually gained in the future.
- Understanding prepaid expenses and how they should be recorded ensures accurate financial reporting, providing a transparent view of a company’s financial health.
Introduction
Let’s say your company signs a lease for an office space, pays the rent upfront for the entire year, and then moves into the office. While the cash outflow has occurred, the benefits of the lease are yet to be fully realized. The money paid upfront in this situation is considered a prepaid expense. Prepaid expenses are payments made in advance for goods and services that have not yet been incurred. It helps companies manage their finances in an efficient way.
In this blog, we’ll break down what prepaid expenses are, why they are crucial for your financial statements, and how to handle them correctly.
What Is a Prepaid Expense?
Prepaid expense refers to the money businesses pay in advance for goods or services they will benefit from in the future. They are recorded as assets on the balance sheet as they have a monetary value. Prepaid expenses are expensed gradually as the value and benefits of the good or the service are realized.
Importance of prepaid expenses
Prepaid expenses essentially help you with financial stability, cash flow management, accurate financial reporting, and budgeting. Let’s understand the importance of prepaid expenses in detail:
- Accurate financial reporting: Recording prepaid expenses accurately on financial statements helps ensure that your company’s financial health and performance are presented correctly to the external stakeholders.
- Cash flow management: When businesses have visibility of their expenses required for smooth operations, they are able to effectively plan for future cash outflows and enhance cash flow management.
- Budgeting and financial management: Paying in advance for goods or services ensures that you don’t miss out on their availability and avoid rising costs due to inflation. Moreover, you can build better relationships with vendors this way and potentially get discounts on future purchases.
Examples of Prepaid Expenses
The most common examples of prepaid expenses include items such as:
- Employee insurance benefits
- Company-related insurance policies
- Taxes
- Interest expenses
- Salaries
- Legal retainers
- Prepaid rent for office space
- Software subscriptions
- Bulk orders of supplies
The payment cycle for such goods and services could be monthly, quarterly, half-yearly, or yearly. These regular payments for these expenses are often recurring in nature.
What Is a Prepaid Expenses Journal Entry?
A prepaid expenses journal entry is an accounting record that acknowledges an expense paid in advance. The journal entry plays a crucial role in maintaining accurate financial reporting for your business.
The mechanics of this entry are straightforward: you debit the prepaid expense account to represent the amount paid in advance, and simultaneously, you credit the cash account to reflect the payment made in accordance with the principle of double-entry bookkeeping. This ensures that your company effectively accounts for the prepaid expense while guaranteeing its proper recognition in your financial statements.
How are Prepaid Expenses Recorded?
There are two major steps to consider when it comes to recording prepaid expenses:
- Initial recording: The initial expense is recorded as an asset in the journal entry as the economic benefit of the good or service will be realized in the future.
- Periodic expense recognition: A periodic entry is recorded in the books; this could be monthly or quarterly, as the company starts utilizing the good or service.
To understand better how prepaid expenses are recorded, let’s consider the following example:
Prepaid rent scenario
A company rents an office space at $1000 per month. They pay $12000 on January 1, 2024 to rent an office space for the year. They will record the following initial journal entry:
Date: January 1, 2024
| Account | Debit (Dr) | Credit (Cr) |
|---|---|---|
| Prepaid rent (Asset) | $12000 | |
| Cash | $12000 |
After a month, the company has gained the benefits of the asset. They will record the following journal entry on January 31, 2024:
| Account | Debit (Dr) | Credit (Cr) |
|---|---|---|
| Rent Expense | $1000 | |
| Prepaid rent | $1000 |
The company will record the same journal entry at the end of every month, till the entire value of the asset is realized, i.e., till December 31, 2024.
How Are Prepaid Expenses Recorded in the Financial Statements?
According to Generally Accepted Accounting Principles (GAAP), expenses cannot be recorded in the income statement until they are incurred. Owing to these prepaid expenses are initially recorded as assets on the balance sheet and are not reflected in the income statement. Prepaid expenses that will be fully incurred within a year are recorded as current assets.
Once recorded an amortization schedule is then established for the prepaid expense. As the economic value of the products or services is realized over time, the asset value is reduced, and corresponding expense is recorded in the income statement. This process continues till the value of the prepaid expense is fully expensed, ensuring alignment of expenses with the accounting period in which they are incurred.
How to Record Prepaid Expenses in Balance Sheets?
Initially, prepaid expenses are listed as assets on the balance sheet, representing their value. As time progresses and the benefits of the assets are gradually realized, the asset is amortized, and the corresponding amount is recognized as an expense on the balance sheet.
This process ensures that the financial statements accurately reflect the timing and impact of the expenses on the company’s financial position and performance.
Let us take a real-life example of prepaid expenses recorded in the balance sheet. We can see below that Hershey’s in their consolidated balance sheet for 2023 has recognized a prepaid expense of $345,588 under assets.
How HighRadius Can Help You with Accurate Financial Reporting
HighRadius offers a cloud-based Record to Report Suite that helps accounting professionals streamline and automate the financial close process for businesses. We have helped accounting teams from around the globe with month-end closing, reconciliations, journal entry management, intercompany accounting, and financial reporting.
Our Financial Close Software is designed to create detailed month-end close plans with specific close tasks that can be assigned to various accounting professionals, reducing the month-end close time by 30%.The workspace is connected and allows users to assign and track tasks for each close task category for input, review, and approval with the stakeholders. It allows users to extract and ingest data automatically, and use formulas on the data to process and transform it.
Our Account Reconciliation Software provides an out-of-the-box formula set that can configure matching rules and match line-level transactions from multiple data sources and create templates to automate various transaction processing required for month-end close.
The Journal Entry Management feature ensures accountability and integrity in journal entry postings. The solution automates your journal entry preparation for identified open items and clearing using customizable LiveCube apps and also automates posting to ERP of your choice. The automated journal entry posting is powered by the LiveCube Task Automation feature that automates data extraction and period-over-period rollover features, reducing manual intervention and increasing efficiency by 50%. These capabilities allow analysts to focus on critical tasks such as audit preparedness, adjustments, and reporting.
Our AI-powered Anomaly Management Software helps accounting professionals identify and rectify potential ‘Errors and Omissions’ throughout the financial period so that teams can avoid the month-end rush. The AI algorithm continuously learns through a feedback loop which, in turn, reduces false anomalies. We empower accounting teams to work more efficiently, accurately, and collaboratively, enabling them to add greater value to their organizations’ accounting processes.
FAQs
1. What is the 12-month rule for prepaid expenses?
The 12-month rule for prepaid expenses allows taxpayers to deduct the prepaid amount in the current year if the use of the asset does not extend beyond the one-year period. As per the 12-month rule, companies don’t need to wait for the asset to be fully amortized to claim tax deductions.
2. What is prepaid account amortization?
Prepaid account amortization is an accounting process that calculates the periodic cost of the recurring expense that is paid in advance. The asset is amortized as it is gradually utilized, and the prepaid expense eventually decreases to zero. The amortization of prepaid assets ensures accurate financial reporting.
3. Are prepaid expenses recorded in the income statement?
As per the accounting principle of GAAP, prepaid expenses are not initially included in the income statement as they are not incurred. They are initially recorded on the balance sheet as assets. As prepaid assets start getting used over time, they are expensed on the income statement.
4. What is the most common prepaid expense?
The most common prepaid expenses include prepaid rent, prepaid utilities, prepaid insurance, taxes, software subscriptions paid for in advance, bulk orders of goods and supplies paid for in advance, taxes, and interest expenses. Such assets help companies improve their financial budgeting and planning.
5. What is an entry for prepaid expenses?
Prepaid expenses are first recorded in the prepaid asset account on the balance sheet as a current asset (unless the prepaid expense will not be incurred within 12 months). Once expenses incur, the prepaid asset account is reduced, and an entry is made to the expense account on the income statement.
6. Is prepaid expense a liability or expense?
A prepaid expense is initially recorded as an asset on the balance sheet, not as a liability or an expense. The prepaid expense is considered an asset because it represents a future economic benefit that the company has already paid for. The prepaid asset is amortized over time and expensed in the income statement.
7. Is prepaid expense debit or credit?
No, prepaid expenses do not have a credit balance. However, these expenses have a debit balance, which keeps reducing as the asset gets utilized over the financial year. These expenses are initially recorded as debit, i.e., when the payment is made and the credit amount is decreased to balance the accounts.
8. Where are prepaid expenses recorded on the balance sheet?
Prepaid expenses are listed as current assets on the balance sheet under “Prepaid Expenses” or “Prepayments.” They represent advance payments for goods or services that will be received in the future and are recorded on financial statements to present an accurate overview of the company’s financial position.
