What are Prepaid Expenses?

What are Prepaid Expenses? | Accounting Smarts
Charles Hall

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Charles Hall

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June 10, 2022

The concept of prepaid expenses can be tough to grasp, and this. This article will tell you everything you need to know about prepaid expenses. So, keep reading if you’re interested.

Running a small business is hard enough without the confusion of business bookkeeping. Yet, it’s impossible to run a legitimate business without keeping correct records of your financial transactions, and prepaid expenses are some of the most important ones. What exactly are they, and what do they mean to your business? 

Prepaid expenses are assets that are recorded on the balance sheet. They are expenses that have been paid in advance, meaning before the item or service has been received by the company. When the company uses the product or service, the expense will be recorded on the income statement. 

The concept of prepaid expenses can be tough to grasp, and this. This article will tell you everything you need to know about prepaid expenses. So, keep reading if you’re interested.

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An In-depth Definition of Prepaid Expenses

Keeping clean financial books is crucial to the financial health of any company, let alone a small business. So, having a solid understanding of prepaid expenses is important. In this section, we will define prepaid expenses in plain English. 

Prepaid expenses are exactly what they sound like, expenses that have been prepaid. The company pays an expense in advance for certain services or products to be delivered in the future. But what’s not so obvious is the fact that prepaid expenses are limited to the money paid for services that will be used by the company within 12 months. 

Whenever you pay for something before you receive it, you should create a journal entry for the prepaid expense for tracking purposes. We will go over how to record a prepaid expense later on in this article.

Prepaid Expenses are Recorded as Assets

It may seem odd that prepaid expenses are treated this way, but there is a clear reason. Prepaid expenses are recorded as assets because these expenses will allow the business to secure some sort of benefit in the future. So, prepaid expenses will be recorded as assets on the balance sheet instead of liabilities. 

You can record them as expenses if that is your preference, but this is not the preferred way to deal with prepaid expenses nor does it comply with generally accepted accounting principles under the accrual method of account.  The main purpose of recording prepaid expenses is it matches the expense to the period in which it is delivered.  This provides more accurate financial statements and provides a better comparison to expenses period to period.

Examples of Prepaid Expenses

If you are still not quite sure about what constitutes a prepaid expense, that’s okay! In the following list, we will go over some examples of prepaid expenses: 

  • Rent. Paying for rent in advance is a very cut and dry example of a prepaid expense. If you pay $5000 in June for the months of July and August, the rent amount is initially recorded as a prepaid expense as soon as it is paid. Then over the next two months, $2,500 of the rent is expensed (used up).
  • Insurance. The same principle can be applied to an insurance policy that you pay for in advance. Imagine a scenario where you pay $12,000 upfront for an insurance policy that lasts 12 months. You would treat this transaction as a prepaid expense and create journal entries that show how $1,000 is expensed for each of the next 12 months.
  • Property lease.  The prepaid expense principle should also be applied to a lease on the business property you pay for in advance. If you pay $15,000 upfront for your lease that lasts three months, you would record this transaction using prepaid expense accounting and create journal entries that show how $5,000 is expensed for each of the next three months. 

These are only a few examples of prepaid expenses- there are many more situations that call for you to use prepaid expense accounting. It’s imperative to record prepaid expenses correctly because if you don’t, your bookkeeping records will not be indicative of the actual financial state of your company. 

Is Equipment a Prepaid Expense?

One of the most common questions that small business owners ask concerning prepaid expenses is whether equipment is considered a prepaid expense. The answer is yes. Equipment could be a prepaid expense if you paid for it in advance. Small businesses often rent equipment for business use, and you would treat a prepaid expense for equipment rental the same as you would a prepaid property lease or prepaid insurance. 

How to Record Prepaid Expenses

It is one thing to be able to visualize prepaid expense scenarios, and another to know how to record prepaid expenses in your financial records. So, we will take you through the prepaid expense accounting steps so that you can record these transactions with ease: 

  • Confirm this is a prepaid expense. Before you even begin to record your prepaid expense, take a few seconds to ensure that your expense meets the criteria for a prepaid expense. This is an important step because if you incorrectly label a transaction, this could throw off your books.
  • Record the full payment amount as a prepaid expense. To do this, you should record that payment as a debit to your “Prepaid expense” account AND as a credit to your “Cash” account. Using the insurance example above, the amount of the prepaid expense will be $12,000. This is all that you will do initially- the following steps will help guide you through adjusting the account every month.
  • Calculate the amount of the monthly adjustment. In this step, you will calculate the amount of money that you will expense every month. If you paid for a 12-month insurance policy for $12,000, you would divide the amount of the expense ($12,000) by the number of months you’ll be covered (12 months). The result is $1,000.
  • Expense a portion of the insurance payment every month. Expense $1,000 of the insurance every month by recording the $1,000 as a debit to the expense account and $1000 as a credit to the prepaid expense account.
  • Repeat the entire expense process every month. You will do this until the policy has been used up at the end of the 12th month. 

We recommend that you read the previous steps closely before you begin making journal entries and adjustments. It’s important not to get confused between credits and debits, as this is the quickest way to end up with a bookkeeping error.

At the end of the process, your asset account should be at $0 since you have completely used up this asset. Also, the expense account should be the same as the full payment amount of the prepaid expense. If either of these is incorrect, something has gone wrong with one of these steps.

If you are still having trouble understanding this concept, you can try using an online prepaid expense calculation tool. 

Alternative Way to Record Prepaid Expenses

There is another way to record prepaid expenses. While the previous method requires recording your prepayment in the asset account, the alternative method requires that you record the entire payment amount in the expense account. To use the alternative method, you should: 

  • Record the prepaid expense as a debit to the expense account and credit cash by the same amount.
  • Adjust the entry each month by the amount of the expense that you used. Do this by debiting your Rent (supplies, equipment, etc.) account for that amount and crediting the expense account by that same amount.
  • Continue adjusting your journal entries until the expense is totally used up. 

Final Thoughts

You now know exactly what a prepaid expense is, how to treat prepaid expenses in your financial statements, and more. Our hope is that this article serves as a resource to help you understand this complex topic.

Charles Hall

Charles Hall

Charles has spent 25 plus years in the world of accounting and business. His experience includes working as a CPA/Auditor international accounting firms. He has worked as a controller and as a COO for small to medium sized companies.

Learn more about Charles Hall