What Are Prepaid Expenses? A Few Things All Accountants Should Keep in Mind
We all know about expenses – those things that cut into our profits but seem to be a necessary evil. What are prepaid expenses and how do they impact our books? Let’s look at prepaid expenses, how they’re recorded, and what effect they have on the financials.
What Are Prepaid Expenses?
Prepaid expenses occur when you pay in advance for an expense that you’ll use up over more than one accounting period. Because the payment of the expense and its actual use to generate revenue aren’t all happening at once, this creates a prepaid expense, which is a current asset on your balance sheet (more on that in a minute). We’ll go over some examples of prepaid expenses and then take a look at how they’re recorded and why they’re recorded the way they are.
Examples of Prepaid Expenses
One very common example of a prepaid expense is prepaid insurance. It’s common to pay for insurance more than one month at a time. Let’s say that you pay upfront for 6 months on your business insurance policy. While this is an expense, the prepayment requires you to record it in your books in a special way, assuming you use the accrual method.
Cash basis small businesses will simply record the advance payment when it occurs. Unfortunately, this doesn’t give us a complete picture of what’s happening. It makes that first month appear far less profitable – because of the lump sum of that expense – and the next five months appear more profitable than they really are.
Accrual-based accounting follows GAAP (generally accepted accounting principles) and specifically, in this case, the matching principle. The matching principle says that expenses should be matched to the revenues they help create. This shows a much more true picture of your working capital, and, obviously, profitability.
In this case, you pay your insurance premium once but have insurance coverage for 6 months. Using prepaid expenses allows you to record the use of that insurance over the entire period and not just in the first month.
How To Record Prepaid Expenses
We just reviewed prepaid insurance expenses as an example. Now let’s use prepaid rent (another common occurrence) to see how prepaid expenses are recorded.
For the sake of simplicity, say you pre-pay six months rent for a total of $6,000. Although you’ve dished out $6k, you haven’t gotten the benefits of that expense yet, so you’ll record a prepaid expense and adjust it over time.
Your first bookkeeping entry will be when rent is paid. Debit the prepaid expense account (prepaid rent) by the prepaid amount to increase it, then the cash account will be credited so the money going out is recorded.
Now, you’ll create adjusting entries at the start of each month to record the expense (note: the first JE could happen right away, depending on when you make that prepayment). For the journal entry, credit the prepaid expense account (also called a prepaid asset account) and credit the rent expense account. This records the actual use of one month of rent.
Why Are Prepaid Expenses an Asset on the Balance Sheet?
As I just mentioned, prepaid expenses are also called prepaid assets and appear as current assets on the balance sheet. This can be confusing, so let’s talk about why that is.
A prepaid asset is a little like a Starbucks gift card (we’ll ignore the technical details of gift card accounting and personal coffee preferences for now). If someone gives you a Starbucks card as a gift, it’s almost like they’ve given you money, it’s just reserved for a certain use. You have buying power in the future that you can use when you need it. And just like cash, that card is an asset to you, meaning it’s something you’ll get a benefit from in a future period.
Prepaid expenses aren’t technically expenses registered on your financial statements. While expenses and revenues live on the income statement, prepaid expenses are tracked on the company’s balance sheet. You can think of them almost like the reverse of accounts payable.
Accounts payable are current liabilities created when you benefit from something before you’ve paid for it. For example, if you purchased something and received a bill but won’t pay it until the end of the month or next month, that’s an example of AP. Prepaid assets are just the opposite, in that you’ve paid for it and won’t benefit from it til later. So, rather than a liability, it’s a current asset to be used up later on. It covers your future expenses as you go and is decreased in a sort of amortization.