Accrual-based accounting is used across all organizations today to apply the matching principle of accounting. This is mainly done to match the revenues for a particular period with the subsequent expenses covered in the given time frame.
This helps to capture the company’s profitability, over the given course of time, with much-needed accuracy.
During the ordinary course of business, several transactions are taking place over the course of time, which is not really consistent with the amount of expenses incurred during that time frame.
In this case, accountants need to segregate the expenses into categories of expenses incurred in the current year and expenses that are supposed to be carried forward.
Prepaid Expenses and Accrued Expenses are the two categories of expenses that constitute expenses paid over (or under) the amount that was due for the particular year.
Prepaid Expenses are expenses that have been paid in advance, whereas accrued expenses are expenses that the organization owes.
Prepaid Expenses make the organization liable to receive a certain good or service. The payment for this particular service has already been paid for. Therefore, it is recorded as a current asset.
This can also be considered as an alternate form of cash (or cash equivalent), where the amount has been paid to the vendor providing that service.
What are Prepaid Expenses?
Prepaid Expenses are expenses that are paid more than the amount that the company owed. In this regard, it is important to consider that prepaid expenses comprise expenses that have already been paid in advance by the organization compare to the amount the company has not yet utilized the product (or service).
It is considered an asset on the balance sheet, and it mainly results from businesses making advanced payments.
Prepaid Expenses in the Balance Sheet
By its definition, an asset is considered resource resourceful for the organization since it helps render profits shortly. They can either be Current or Non-Current. Current Assets are assets that are likely to provide an incentive to the company within 12 months.
Non-Current Assets, on the other hand, are long-term investments that are likely to continue rendering profits (or cash flows) for the company for more than 12 months.
If the company makes an advance payment to a supplier for any particular good or service, they are building up an asset. This is because they have already paid the amount, yet the service is yet to be utilized.
Therefore, it makes sense to treat it as a Current Asset until the company does not render the respective service. It is treated as a Current Asset (and not as Non-Current Asset) because in most business cases, the amount paid in advance lasts for a shorter duration than 12 months.
However, the amortization of this asset only takes place once the company utilizes the said service. This can be done across a period after the given year. As the company uses the offered service, then the amount gets expenses in the Income Statement.
In other words, it stays in the Balance Sheet till the point where it is not utilized (but paid for), and after that, as it is expensed, it is then declared in the Income Statement as an expense for the respective year.
Difference between Prepaid Expenses and Other Current Assets
As mentioned earlier, Prepaid Expenses are mentioned on the Balance Sheet as a Current Asset. Other Current Asset types include Inventory, Accounts Receivable, and Cash and Cash Equivalents.
Prepaid Expenses are different from all the different types of current assets because, in those classes of existing assets, the company is bound to receive cash (or it already has cash) against the given services.
On the other hand, prepaid expenses imply that a company is liable to receive a service (or goods) against which they have already made the payment.
Hence, it can be seen that prepaid expenses, although different from other classes of current assets, serve the same purpose in providing the required results.
Examples of Prepaid Expenses
There can be several different examples of prepaid expenses commonly found on the company’s Balance Sheet. Some of these examples are given below:
- Prepaid Rent: Rent for future months that are paid in advance)
- Prepaid Utility Bill: Utility Bill paid in advance for coming months that are still unaccounted for.
- Prepaid Insurance: The insurance policy that has been acquired and paid for has not been utilized yet.
These are some of the most common examples of prepaid expenses and how they are represented in the financial statements:
Treatment of Prepaid Expenses
Prepaid Expenses are found on almost every financial statement across different companies. In this regard, it is essential to ensure that the treatment of prepaid expenses is adequately adhered to so that there are no inconsistencies in preparing financial statements.
The treatment of the most common prepaid expenses is illustrated in the examples given below:
Treatment of Prepaid Rent
Mocha Inc. acquired a new office space on rent on 1 January 2019. As per the agreement with the landlord, they were supposed to pay an advance rent of 2 years (up to 31 December 2020).
The rent per month amounted to $200 for the given space, and there was no change to this charge over the two years.
From the example given above, it can be seen that Mocha Inc. paid an advance rent for all the year 2020.
Therefore, for the year ending 31 December 2019, they had ‘expensed’ a rent-charge of $2400 ($200*12). However, they had also paid an advance rent for the year ending 31 December 2020.
Therefore, the amount of prepaid rent that will be presented on the Balance Sheet at the year-end 31 December 2019 amounts to $2,400. This is going to be represented as Prepaid Rent under the Current Assets.
Treatment of Prepaid Insurance
Rose Corporation pays $6,000 in Insurance Premium for coverage of directors, chairman, and company’s overall staff. They spend this amount upfront and then adjust every subsequent month to reflect the insurance expense incurred (and the insurance expense prepaid).
In the example mentioned above, it can be seen that upon payment of $6000 for Prepaid Insurance, the following journal entry is going to be made:
|Prepaid Insurance (Current Asset)||$6,000|
Subsequently, it is essential to adjust entry to change the prepaid insurance figure at the end of every month and expense the appropriate amount in the Income Statement.
Since the yearly charge is $6,000, the monthly payment for Insurance can be $500. The adjusting entry for this is as follows:
|Prepaid Insurance (Current Asset)||$500|
Followed by this adjusting entry, the remaining balance of Insurance expense amounts to $5,500. This keeps on reducing overtime, and for every subsequent month, the amount is expensed as the service is utilized.