Companies incur expenses to help in generating revenues. These revenues can allow companies to make profits. If companies don’t spend, they cannot make sales.
Therefore, expenses are crucial in helping companies operate and continue their activities. Some may view these spendings as unnecessary. However, they support the revenues that companies generate through their operations.
Companies usually pay for small expenses as they occur. The accounting for these expenses involves recording the cost incurred and the amount paid in exchange.
However, some expenses may also occur before or after the actual payment to the supplier. In accounting, the accrual concept requires companies to record those expenses as they occur. The cash payment or compensation does not dictate when companies recognize them.
On top of that, when companies incur an expense, it is a separate transaction. Once they pay for it, that transaction will be different. Companies must also segregate expenses based on when the payment occurs. Usually, companies pay their suppliers after receiving goods or services. They record these expenses as accrued expenses. For the company, they constitute current liabilities in the balance sheet.
Some companies may also pay for expenses in advance, for example, prepaid rent. The accounting for these expenses is straightforward. However, some may wonder where they go on the cash flow statement. Before discussing that, though, it is crucial to understand prepaid expenses.
What is a Prepaid Expense?
As mentioned above, companies usually pay for expenses as they occur. In some cases, they may also repay the supplier after the initial transaction. Both parties agree to the terms of these payments in advance. For most companies, this difference between expenses and payments is crucial when accounting for them. In most cases, these are the only variations that companies may experience.
Sometimes, however, suppliers require customers to pay them in advance. Usually, suppliers need these payments to ensure future sales. These payments serve as the customer’s commitment to the future transaction between them. For the supplier, it can also provide funds to produce products. In some cases, although not required, companies may pay their suppliers in advance as a token of good faith.
One of the most common forms of prepaid expenses includes prepaid rents. When leasing or renting property, landlords require tenants to pay rent in advance. This practice is common in real estate, and companies must adhere to it. Prepaid rent is a mandatory expense to obtain rights to use a property. This property may be for official use or include factories, plants, etc.
Prepaid expenses are also common in other areas, for example, insurance. Companies pay insurance premiums in advance, which they must record as a prepaid expense. Once the company receives the service or product in exchange, it can recognize the underlying expense. Consequently, it becomes a part of the income statement. Before that, the prepaid amounts stay under current assets in the balance sheet.
Overall, prepaid expenses are money paid to suppliers in advance for future transactions. These expenses are mandatory in some industries, and companies must adhere to them. One of the most common forms of prepaid expenses includes prepaid rent.
When companies obtain the rights to use a property from a landlord, they must pay an advance. This advance constitutes prepaid rent and becomes a current asset in the balance sheet.
Does Prepaid Rent go on the Cash Flow Statement?
As mentioned above, prepaid rents primarily impact the balance sheet. When companies pay these rents in advance, they recognize them as a current asset. This amount remains in the balance sheet as long as the company does not use the underlying property. Once the period for the rent is over, companies can record the amount as an expense. Consequently, it also impacts the income statement as an expense.
However, some may question whether the prepaid rent goes on the cash flow statement. The answer to that question is yes. Prepaid rents become a part of the cash flow statement when paid. However, this payment must occur through cash and cash equivalent resources. Any compensation paid in other resources does not become a part of the cash flow statement.
Usually, prepaid rent goes under cash flow from operating activities in the cash flow statement. This treatment only incurs if the rent relates to a property used for operations. For example, prepaid rent on office buildings or factories falls under operating activities. If companies pay rents on properties used for other purposes, this treatment may not apply. Usually, however, these circumstances are rare.
Most companies prepare the cash flow statement through the indirect method. In this method, companies do not report their cash flows directly. Instead, they include them under three headings. These include cash flows from operating, investing, and financing activities.
Although prepaid rent falls under operating activities, companies do not report them directly. Instead, they consist of them as an increase or decrease calculation.
The increase or decrease calculation applies to all current assets and liabilities. Under this treatment, companies extract items from the balance sheet to report in the cash flow statement. They compare those figures to the previous year’s values.
Once they do so, they calculate whether they have increased or decreased. An increase in current assets constitutes cash outflows for companies. In contrast, an increase in current liabilities forms cash inflows.
Example of Prepaid Rent on Cash Flow Statement
The cash flow statement includes three sections, cash flows from operating, investing, and financing activities. Prepaid rent, as mentioned above, goes on the operating activities section. When companies pay rent to a landlord, they record it as an asset. Usually, these rents only cover the next 12 months or less. Therefore, they become a part of current assets in the balance sheet.
For current assets, the indirect methods of preparing the cash flow statement require specific treatment. As mentioned, this treatment involves calculating whether the item under this heading has increased or decreased. Typically, companies report their prepaid rents as follows under operating activities.
|Cash flows from operating activities|
|Net profits / (losses)||XXXX / (XXXX)|
|Non-cash item adjustments||XXXX / (XXXX)|
|Additions / subtractions from cash|
|– (Increase) / Decrease in prepayments||(XXXX) / XXXX|
|– (Increase) / Decrease in other current assets||(XXXX) / XXXX|
|– Increase / (Decrease) in current liabilities||XXXX / (XXXX)|
|Net cash flows from operating activities||XXXX / (XXXX)|
In the above example, the increase or decrease in prepayments covers prepaid expenses. This difference comes from the balances recorded for the heading in the balance sheet.
As mentioned above, if the amount increases, it constitutes cash inflows. When companies pay more prepaid expenses, the amount on the balance sheet increases. Therefore, an increase becomes a cash outflow from prepaid expenses.
On the other hand, if prepayments decrease in the balance sheet, it is an outflow. When companies pay lower prepaid rents or use up the amount, it will reduce.
This reduction does not imply the company received an inflow from those rents. Nonetheless, the indirect method of cash flow statement reports it as a cash inflow. This inflow offsets the expense recorded in the income statement, which becomes a part of net profits.
Prepaid expenses occur when companies pay for a product or service in advance. These expenses may be mandatory in some cases. For example, landlords require tenants to pay for the underlying property in advance. Prepaid expenses constitute cash outflows for the business.
However, companies report them in the statement as increases or decreases. Prepaid expenses go on the cash flow statement under operating activities.