The accrual accounting system is the most prevalent method of accounting used by small businesses and large corporations.
The method implies that the expenses and revenues should be part of the income statement only in the financial year they are incurred or earned.
It means that cash payment or receipt of the expenses and revenues is a separate matter and recorded in the statement of cash flows.
The opposite of the accrual accounting system is a cash basis. Under the cash basis system, the expenses and revenues are not recorded until the cash element is included. Therefore, the prepaid expenses are recorded as debit of cash, and receiving unearned revenue is a credit of cash.
The treatment of prepaid expenses, unearned revenue, accrued income, and expenses vary in accrual and cash accounting.
Since accrual basis is a more popular and widely used accounting system, we will focus on that. However, we will also talk about the treatment of different economic transactions on a cash basis.
Prepaid rent is a prepaid expense that must be recorded in the company’s financial statements. But how?
We will discuss the accounting treatment for the prepaid rent on an accrual and cash basis. We will also answer if prepaid rent is a current asset or liability. So let us get into it.
How Are Prepaid Expenses Recorded?
Prepaid expenses are the future expenses paid in advance and treated as a current asset on the balance sheet until the expenses are incurred.
The current asset account decreases when the expenses are realized, and the expense account increases. Prepaid rent, prepaid insurance, utility bills, interest, etc., are an entity’s most common prepaid expenses.
What Is Prepaid Rent?
Prepaid rent is a prepaid expense of any business entity, and we can define it as,
“The amount of rent paid in advance and not in the period when the rent is due is called prepaid rent. In most cases, rent is a prepaid expense since it is paid at the start of the rental period.”
It’s common for the tenants to receive the rent in advance, which can be monthly, semi-annually, annually or as agreed between the contract parties.
This results in a problem with prepaid expenses for the entities following the accrual system of accounting. Therefore, businesses must record the rent paid in advance on the company’s balance sheet. No effect is shown in the income statement of the company.
A common concern of business owners who do accounting by themselves is whether the prepaid rent is an asset or liability.
Besides, the categorization of advance rent in current and non-current assets is also significant. Therefore, let’s answer the question by differentiating between the current and non-current assets and current assets and liabilities.
Is Rent Expense Debit or Credit?
Rent expense is different from prepaid rent. Prepaid rent expense is the current asset account and is recorded in the balance sheet while rent expense is the expenses account which is recorded in the income statement of the company.
Like other expenses accounts, increasing the rent expense is recorded on the debit side while decreasing it is recorded on the credit side in the company’s income statement during the time rent is incurred.
Assets Vs. Liabilities
Assets are the resources or items owned by a business entity or individual. On the other hand, liabilities represent the financial obligations of an entity or an individual. Assets and liabilities are further categorized as short-term and long-term assets.
The difference between assets and liabilities is that assets increase the net value of an entity. In contrast, the liabilities of an entity result in a net loss of value. Both assets and liabilities are recorded in an entity’s balance sheet and represent a company’s financial health snapshot.
Non-Current Assets Vs. Current Assets
Non-current assets (long-term) and current assets (short-term) are categories of assets owned by an entity. The current assets are the short-term assets that can be quickly converted into cash.
It includes cash, cash equivalents, prepaid items, and receivables. Usually, the current assets include items that can be converted into cash within 12 months.
The long-term assets or non-current assets include the items and resources that cannot be quickly converted into cash.
The period of non-current assets usually expands from 2 years to 10 years or more. Property, plant, equipment, and fixed assets are part of the long-term assets.
Is Prepaid Rent Expense or Revenue?
Now to the prepaid rent, is it an expense or revenue?
We all know expenses represent the costs of an entity that are necessary to be paid off in order to perform different operations. In contrast, revenues represent the income received by an entity against the services provided to clients.
The prepaid rent is neither an expense nor revenue for the company because it doesn’t fulfill the expense or revenue definition.
We know that prepaid rent represents the amount of expense that will be due in future periods. However, it’s not an expense from an accounting perspective.
Is Prepaid Rent A Current Asset?
If prepaid rent is neither an expense nor revenue, what will be the accounting treatment of the item?
Is it a current asset or liability?
Prepaid rent is the amount of cash paid by an entity against the future rental periods. Although the cash has been debited, the entity has not utilized the service yet. Therefore, it can be believed to be an asset for the company.
Prepaid rent is recorded as a current asset on the company’s balance sheet.
The prepaid rent is usually paid for a month, two, six, or a year. Therefore, it fulfills the definition of the current assets and is recorded under the head of current assets on the balance sheet.
Is Prepaid Rent Debit or Credit?
Now, prepaid rent is debit or credit for the company. We have already determined that prepaid rent is an asset for the company.
An increase of an asset is recorded on the debit side of the entry. The increase of prepaid rent assets is against the decrease of another asset (cash/bank). Therefore, the entry is made by debiting prepaid rent and crediting cash/bank.
We can say that prepaid rent has a normal debit balance. However, when the services are taken during the rental period, the prepaid rent is credited, and the rent expense will be debited.
Accounting For Prepaid Rent
Let’s have a look at accounting for prepaid rent on both accrual and cash basis.
Accrual Basis Accounting
In the accrual basis of accounting, prepaid expenses’ payment is recorded as an increase of prepaid rent in current assets.
At the same time, cash, another current asset, is decreased and credited. The journal entry for the recording of prepaid rent when paid and not due is as follows:
|Prepaid Rent Account||xxx|
|(Prepaid rent paid in advance)|
At the end of the rental period, the prepaid rent has become the expense incurred. Therefore, the current asset is decreased by crediting the prepaid rent. On the other hand, the expense account is increased by debiting the rent expense. The journal entry will be as follows:
|Rent Expense Account||xxx|
|Prepaid Rent Account||xxx|
|(The rent expense is incurred by decreasing the prepaid rent account)|
The effect of these entries is also recorded in the company’s income statement and the balance sheet. In the period when prepaid rent is paid but not due, there will be no record in the income statement.
However, the cash flow statement will show cash outflow against operating activities. Besides, the prepaid rent is recorded as a current asset on the company’s balance sheet.
Once the rent expense is due and incurred, the rent expense is recorded in the income statement of the respective financial year.
Besides, the current assets in the balance sheet are decreased as the prepaid rent is not an asset anymore. Suppose the entity has paid rent for six months and prepares financial statements on a monthly basis.
In that case, the amount of rent for one month will be subtracted from the prepaid rent recorded on the balance sheet.
Suppose a company follows the cash basis of accounting. In that case, the prepaid rent is recorded in the period when the cash is paid.
It is irrespective of when the cash will be due. Whereas the income for coming periods will be overstated since no rent expense is recorded. Therefore, it’s not fair as the income of the period when cash is paid becomes understated due to outflow.
We have discussed prepaid rent, the nature of economic transactions such as debit or credit, the balance sheet, income statement recording, and financial reporting.
We hope you will be able to identify the prepaid rent as an asset or liability in the financial statements of an entity.