A prepaid expense is an expense that is paid for in advance. Recurring expenses such as insurance and rent can be paid for with one payment that covers the cost of the expense for several months or even a year.
Often, businesses prepay expenses in this manner because they can receive a discount.
Prepaid expenses also provide a benefit to a business by relieving the obligation of payment for future accounting periods. In this manner, prepaid expenses are considered an asset.
Anything that has economic value to a business is considered an asset. Prepaid expenses are considered a prepaid asset because the item that is paid for in advance, such as the rent or insurance coverage, has monetary value. Prepaid expenses are also considered a current asset because they can be easily liquidated—the value can be realized or converted to cash in one year or less. However, every asset has a cost. The value of the prepaid asset is offset by the cost of the expense in each of the affected reporting periods.
Recording a prepaid expense is a multi-step process. The expense will be debited as an asset in a prepaid account, such as insurance or rent.
It will be credited for the same amount of the full expense in the cash account, from which the payment was drawn.
As the expense is used up, monthly incremental payments will be credited to the asset, and debited in the appropriate expense account, such as insurance expense or rent expense.
By the time the expense is fully used up, the asset value will have reached zero, and the expense will now total the full amount that was paid. In this manner, the asset entry and the expense entries will cancel each other out.
A common type of prepaid expense is the payment of rent. For example, if a business was to pay for a year’s worth of rent on its building, and rent is $10,000/month, the payment would be debited initially as a $120,000 prepaid asset.
It would also be credited for the same amount in the cash account. Each month, an adjusting journal entry of $10,000 (the equivalent of one month’s rental payment) will be credited in the prepaid rent account and debited in the office rent expense account.
At the end of 12 months, the office rent expense account will appropriately show a cumulative total of $120,000 in payments for the past year, and the value in the asset account will be depleted to zero.
Businesses prepay expenses for a few reasons. They may incur savings by paying for expenses up front because some providers will offer discounts for products and services when they are paid for in advance.
Similarly, prepaying for certain expenses affords the opportunity to lock in current rates.
A business can also deduct some prepaid expenses on its income taxes. If a business is looking to increase its deductions to help lower its taxes in a given year, prepaying for some of its expenses may be an effective strategy.
A business must calculate the monthly cost for a prepaid expense. This is referred to as the prepaid expense amortization. Amortization is an accounting term that refers to the reduction in value of an assert over time. Prepaid expenses amortization is the calculation of the cost of the expense in increments. Another way to describe this is to consider what the cost of the expense would be if it was paid for in regular monthly installments instead of all at once.
To do this the business will divide the total value of the asset by the number of months it will last. This is expressed in equation form as: monthly expense = total value ÷ number of months.
Businesses make a number of prepaid expenses:
Advertising
Bulk orders of supplies
Insurance
Interest
Legal retainers
Rent and leases
Salaries
Taxes
It’s important to record prepaid expenses because a business should correctly record all of its transactions and resources to have accurate financial statements.
Recording a prepaid expense as an asset and adjusting that asset as the expense is consumed on a monthly basis ensures that the business is accurately recording the true value over time, and in particular, how paying in advance affects the business’s finances from one month to the next.
Request a demo a with us and we will show you how our accounts receivable automation software can maximize your working capital with the only unified platform for collecting cash, providing credit, and understanding cash flow. It's time for modern accounts receivable.