Don’t let the word “expenses” in prepaid expenses fool you. Despite the name, prepaid expenses aren’t recorded as expenses initially — they’re considered assets.
And you have to be careful while recording them. Immediately expensing prepaid expenses can cause profits to fluctuate, making performance benchmarking over a period of time difficult. Failure to adjust these expenses accurately leads to the account balance remaining the same, which overstates the value of any prepaid expenses as an asset. Inflated assets can cause problems with budgeting and when it’s time to file taxes.
What Are Prepaid Expenses?
A prepaid expense is an advance payment for goods or services that are received in the future. A prepaid expense is recorded as a type of asset on the balance sheet and as an expense on the income statement when it’s utilized.
Prepaid expenses cannot be expensed as soon as you pay for a service or goods because your business benefits from it over a period of time. And according to GAAP (generally accepted accounting principles), when you record an expense, you must realize the benefit from the asset in the same accounting period.
For instance, you decide to rent a copier for the year. This copier benefits your company for the whole year, instead of a month or a quarter which is generally the accounting period.
Prepaying expenses has several benefits. Paying upfront can help you avoid the rising cost of goods and services, receive a discount, and take advantage of tax deductions.
What Is Prepaid Expense Amortization?
Amortization is an accounting technique that helps you account for the consumption of a prepaid expense over a period of time. This process shifts the asset from the balance sheet to the income statement.
Let’s say you pay $12,000 to lease an office space for a year. Since this expense is spread over 12 months, through amortization, you would divide the total amount by 12 to calculate your monthly rent, i.e., $1,000. To represent this accurately, you would have to enter this amount as a rental expense every month in the income statement and reduce the rental prepaid expense by the same amount simultaneously.
Examples of Prepaid Expenses
Prepaid expenses are actually quite common. Insurance premiums, prepaid rent, salaries, taxes, or any interest or installment paid for office equipment are all examples of prepaid expenses.
Common Types of Prepaid Expenses
Since insurance is always paid for in advance, it is always recorded as a prepaid expense. If you’re taking coverage for the entire year, it would be recorded as an asset at the time of payment and then expensed over the course of the 12 months.
When you lease an office space, you can pay in advance to lock in the price or avail a discount. This advance will also count as a prepaid expense.
Legal Services Retainer
Law firms require a retainer to begin representation. This retainer amount is recorded as an asset because there is no immediate benefit. It will only be recorded as an expense when legal services are utilized.
What Is the Process for Reporting Prepaid Expenses?
When you prepay an expense, you have to first record it as a prepaid asset on the balance sheet. At the same time, you have to make an entry to reduce the cash account by the same amount.
When you finally incur an expense, the prepaid expense account is reduced by the amount of the expense, and it is recorded as an expense on the company’s income statement in that accounting period.
Note: Unless you don’t realize the benefits until after 12 months, most prepaid expenses are reported as a current asset. And you cannot claim tax deductions on prepaid expenses if you don’t incur the benefits in that financial year.
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Here are the steps to record prepaid expenses:
Create a Basic Entry After Payment
Let’s say your insurance coverage for the entire year costs $24,000. Create a journal entry to debit this amount under the prepaid insurance account. Then credit the cash account by the same amount.
- Record the Expense in Your General Ledger
You have to now record the expense for the next 12 months. You can use software to automate this process or create an amortization schedule to do this manually. This is what it would look like at the end of January:
Note: If the expense is realized sooner than 12 months, you will need to calculate and create an amortization accordingly.
Debit the Asset Account and Credit the Cash Account
Every month, you have to debit the asset account by $2,000 and credit the cash account by $2,000 until you reach the end of the year.
Your prepaid insurance account will steadily reduce while your insurance expense will increase.
Repeat the Process Till the Prepaid Expense Account Is Reduced to $0
At the end of 12 months, you will create the final journal entry. This entry will close out your prepaid insurance balance to $0, while your insurance expense for the year will be $24,000. The final entry in December will look like this:
Report Prepaid Expenses With Datarails Automatically
Amortizing prepaid expenses can be a challenge for companies that rely on manual accounting processes because this leaves room for human error. If you forget to record an expense or add an expense that has already been amortized, it can result in inaccurate financial reporting, which can impact business decisions and tax deductions.
Fortunately, you can significantly reduce the risk of errors by automating the entire reporting process. And with an Excel-based solution like Datarails that fits into your existing workflow, you don’t even have to waste time and resources to learn a completely new tool.