What are Prepaid Expenses?
Some stories don’t end up the way they were meant to be. If you want things to be as they are, you need to know how to plan ahead. Whether it’s your life or your business, you need to take into account future payments, for instance.
Unless you prepare well, you could get into a financial rut, one you would most likely want to avoid.
And that’s what prepaid expenses are all about. It helps you stay ahead, and prepare from before.
Let’s say you recently bought a car and paid insurance for it.
The insurance isn’t going to help you right now. You will benefit if you meet with an accident or any unforeseen incident in the future. Or, you may claim the insurance if you want to replace an expensive part of your car.
Insurance, however, is just one of the types of prepaid expenses. Even though they are a liability, in the beginning, they become beneficial over a long period of time. Businesses will want to have enough prepaid expenses to cover future payments, and have the money ready when you need it.
You will need to report it on the balance sheet, and only when the asset expires will you need to write it on the expense sheet.
Confused as to how that happens?
Read on, as we talk about all the prepaid expenses that your company needs to deal with, and the income statement that you need to make.
After all, just understanding the management expense ratios isn’t going to help you when it comes to having a successful business.
HOW DO PREPAID EXPENSES HELP YOU IN YOUR BUSINESS?
Do you own company vehicles? We are sure you have vehicle insurances for them. The prepaid expense will refer to the yearly insurance payment in advance that you have made for all the vehicles.
So, your income statement for the year will actually have one twelfth of the amount you have prepaid at a time, and will be debited to the insurance expense head.
These expenses are valid only for a limited amount of it. In the business world, a prepaid expense is considered as an asset. Only when the asset goes unused during its validity period, it is considered as an expense.
For example, you paid $1,000 as your car’s insurance premium for two years, but you didn’t use it. You will not get the money back. After the insurance expires, you have to renew it, which is the usually same amount as the previous premium you paid.
Here is a look at another example of a prepaid expense.
In business terms, a prepaid expense is money you pay in the present for services or products that will be used in the future. You can pay for a prepaid expense in the current financial year and use it in the next financial year until and unless it is valid.
Prepaid expenses are subject to time and affect a company’s balance sheet and income statement. They are balanced at the end of the company’s billing period, which can be monthly, quarterly, half-yearly, and yearly.
DIFFERENT TYPES OF PREPAID EXPENSES
When you talk about prepaid expenses, you talk about accounting, which makes it a purely business term. Companies use it as a part of their balance sheet to identify its profits and losses.
Insurance is just one of the prepaid expenses that you pay. Let’s take a look at the remaining types of prepaid expenses.
1. Legal fees
Lawyers and companies enter a retainer agreement, which binds them together in a business contract. The companies have to pay retainer fees to the lawyer as a sign of appreciation, which is calculated in terms of the professional services the lawyer will offer in the future.
When the business renders a service, the amount is deducted from the prepaid credit tab and added to the legal expenses account.
Many commercial rent agreements ask businesses to pay the first and last month’s rent along with the deposit to make the contract valid. Just like legal fees, when the first month is over, the prepaid rent amount is transferred from the credit tab to the rent expenses account.
The same transaction takes place during the last month of the lease period. Rent payment of the months in between is typically paid after the month ends.
Corporate firms pay quarterly estimated tax to reduce the tax liability at the end of the financial year. Even though companies have to pay the amount, it is considered as a prepaid tax until they make the final tax payment.
Businesses do this to reduce the work at the end of the year so that they can concentrate on the core business activities. The accounts are cleared quarter-wise and the process is a lot faster.
4. Utility bills
Utility bills include water, gas, and electricity bills but are usually charged at the end of the month, depending on how much you used each of the resources.
However, corporate firms go for prepaid utility bills, wherein they pay for a fixed usage at the beginning of the month or decided period. It like paying for an internet plan, which you have access to only after paying the fees.
Companies have to pay in advance when they order supplies in bulk quantity. It is recorded as a prepaid expense until the company receives the stock.
Insurance is purchased with the intention of safeguarding the company’s assets. If the company paid $1,200 for one year’s insurance, it is divided into 12 months. In the beginning of the year, the whole amount is put under the prepaid expense tab.
After one month, $100 is transferred to the insurance expense tab. As every month passes, $100 keep getting transferred until it is time to renew the insurance.
Cash management seems to be the keyword here.
WHY DO YOU CONSIDER PREPAID EXPENSES AS ASSETS?
Every aspect of business is important, whether it is understanding financial ratios or the money you’ve to incur every year.
Like we explained before, a prepaid expense is something you have already paid for either partially or completely and haven’t used yet. It is valid for a limited period of time, during which you can take its benefit. Any expense that hasn’t expired and can be used in the future is termed as an asset on the balance sheet.
For example, you want to claim insurance on the electronics used in your office that were damaged because of a rainstorm. The insurance company will pay for the new electronics. You won’t have to take out any money from your pocket. You can consider prepaid expenses as emergency funds that offer relief during times of distress. When the time limit expired, it is moved to the expense section.
Let’s talk about something more simple. You have to fly from Miami to Chicago, where your family stays, during Easter weekend and you book an airplane ticket for it. You make the payment and receive an email about it. The booking that you made in advance is an asset. When you go to the airport and show the ticket, you will be directed towards your flight. Your flight booking is a prepaid expense that you made to visit Chicago.
If you would have directly gone to the airport on Easter morning and booked a flight, which leaves in two hours, you didn’t make a prepaid expense. You booked at the time of check-in and flew to Chicago.
Many people get confused between a liability and an asset. They put a prepaid expense as a liability, but that is a wrong consideration. A liability is an unpaid or outstanding expense, which you pay after you receive the service. One good example of liability is the utility bill that you have to pay after calculating meter readings.
RECORDING PREPAID EXPENSES IN YOUR BALANCE SHEET
You can divide the process of recording prepaid expenses into two parts — journal entry of the prepaid expense and adjustment.
Journal entry of the prepaid expense
Step 1. You, the company, receive an invoice from the supplier and verify it with the concerned team members. They go through the terms of the agreement and judge it against their assets and company requirements.
Once approved, you notify the supplier that you are ready to enter the agreement. For example, an insurance company sends you the invoice of $1,000 as a yearly insurance payment.
Step 2. Both parties sign the agreement, and you make the payment and receive a receipt of an acknowledgement from the supplier.
Step 3. Add it under insurance in the prepaid expense tab, which falls under the assets category. Make sure you match the revenues with prepaid expenses because it becomes convenient to tie back the two in the future.
Adjustment of the prepaid expense
At the end of every accounting period, which can be monthly, quarterly, or annually, settle the prepaid expenses with the expense account. When it comes to insurance, you usually divide it into 12 months and deduct from the prepaid expense and add to the expense account as the time goes by.
In this part, you only adjust the expense, so there are no additional costs. Verify all accounts to make sure that is settled and match the expenses and revenue generated.
TIPS TO MANAGE PREPAID EXPENSES
Handling prepaid expenses can be challenging because they are easy to forget and take a lot of efforts to track over the period of time. Here are some tips that will help you while managing prepaid expenses:
Don’t record small prepaid expenses
It is best to not mention small prepaid expenses like stationery you order monthly because they are difficult to track. You will have to do a lot of back and forth, which is a huge waste of time.
Mention them in the balance sheet when you receive the order under the expense account. If you still want to record the small prepaid expenses, you can create a separate chart when you mention all the payment but don’t add them in the balance sheet until you receive the products or services.
Make multiple categories
Prepaid expenses are put under the asset category. To make sure you maintain a proper record, divide the prepaid expenses into sections and subsections according to their nature.
If your company has three insurances, for example — electronic insurance, business insurance, high-level management insurance, list them all separately, so you don’t have to worry about what money went where.
Other sections you can make under prepaid expenses include prepaid tax, utilities, supplies, and anything major you pay for in advance.
Set alarms for transactions
It is easy to forget the date to make transactions from prepaid expense to expense account. The best way to remember it is by setting the alarm or reminder for it at the very beginning. It takes away the stress and gives you more time to concentrate on ways to improve your company and bring in more business.
Set up a recurring journal entry
A journal is a document that you use to record all transactions. When you make the transaction from prepaid expense to expense account, mention it as a recurring entry in a journal. It will help you to cross check and settle the accounts at the end of the year.
WAYS TO RECORD PREPAID EXPENSES
The type of recording a company goes for, completely depends on the nature of the business and legal advice it received. It directly affects the company’s financial records.
In accrual accounting, the company records expenses as and when they are utilized. In other words, the company doesn’t add any prepaid expense to their balance sheet when the money is transferred to the service provider. For example, if the company paid an entire year’s rent, which cost it $24,000, the company will add $2,000 under the rent expense tab at the end of a particular lease m
This method aims at reducing the back and forth you have to do if you practice the cash accounting method.
The cash accounting method is the traditional method in which you record the payment under prepaid expenses as soon as transfer the money. Its action doesn’t concern if you received the service or products as promised by the seller.
Traditional companies choose to follow the cash accounting method because it helps them remember the expenses incurred. However, startups are often going for the accrual account method. The primary reason remains that it requires less work. In such circumstances, the company keeps a journal for all the prepaid expenses.
BENEFITS OF A PREPAID EXPENSE
Practicing the art of prepaid expense offers only two but crucial benefits. Let’s take a look at the benefits:
A tax deduction is the biggest advantage of the prepaid expense practice. When you mention it as an asset on your balance sheet, you pay the tax for it in advance. You also receive certain tax benefits when you invest in an insurance policy.
Many corporate firms prefer to pay the pay an entire year’s rent in advance as it lets them avoid future expenses. The company pays the amount at the current rate and is not subject to future increase in the price. You end up saving a lot of money, which is helpful during times of inflation.
SHORT-TERM AND LONG-TERM PREPAID EXPENSES ASSETS
A company typically divided prepaid expenses under two categories depending on its duration. All prepaid expenses that have a validity of 12 months or less are considered as short-term expenses. On the other hand, long-term prepaid expenses are all expenses that were made for longer than 12 months.
Companies only mention 12-month expenses of long-term prepaid expense assets in the net working capital calculation. The remaining amount and months are carried over to the next year.
DIFFERENCE BETWEEN PREPAID EXPENSE AND DEFERRED EXPENSE
The deferred expense is a prepaid expense that you use over a year after you make the payment. It is usually mentioned as a long-term asset on the yearly balance sheet.
On the other hand, a prepaid expense is something that you use up within a year. If a company doesn’t use the categories short-term and long-term prepaid expenses assets on the balance sheet, they replace it with the prepaid expense and deferred expense.
Common deferred expense examples include legal fees and rent paid for over a year. Let’s take an in-depth look into the world of deferred expense.
Your company wants to set-up a new cookies manufacturing unit and hires a law firm for looking for the legality. Both parties agree to draw a contract of $250,000 for ten years, which includes the legal consultation fees. You will have to pay the entire amount as soon as you enter the agreement and put it under the deferred expense tab.
After a year passes, you only deduct $25,000 from the deferred expense tab and put it under the legal expense tab. The remaining amount, which is $225,000, is still considered as the company’s deferred expenses.
Some companies prefer to manage their balance sheet on a half-yearly basis. In such circumstances, the insurance premium that you pay for a year is put under deferred expense. Half of the amount is transferred under the insurance expense chart in the half-yearly balance sheet.
Other terms for deferred expenses include non-current expenses and long-lived expenses. Companies use these terms simultaneously to define deferred expenses, but they all mean the same thing. This also means that over time deferred expenses become prepaid expenses as its timeline shrinks.
Deferred expenses are different from deferred revenue as the latter term means payment the business receives for its products or services before the customer receives them. For example, you order a dress online for your daughter and pay using your credit or debit card. The fashion brand sends you the dress only after it receives the payment.
DIFFERENCE BETWEEN ACCRUED EXPENSES AND PREPAID EXPENSES
Accrued expenses and prepaid expenses are exactly the opposite to each other. While a prepaid expense is something that you pay in advance, an accrued expense is something that you pay for after receiving the products or services. Examples of accrued expenses include salaries, postpaid utility bills, and credit card payments.
Accrued expenses are usually a part of the business to business transactions. Accrued means on interest or on loan. Also known as a credit transaction, these type of expenses are done when one business uses products or services of another but doesn’t pay the money immediately. The company doesn’t receive an invoice for it. Accrued expenses are put under current liabilities tab in the balance sheet along with the company’s other short-term liabilities.
For example, a company XYZ has 15 employees, and their total monthly salaries account for up to $1,500,000. At the beginning of the month, the company will put Monthly Salaries under Current Liabilities in the balance sheet. After the payments are made on the last day of the month or during the first week of the next month, the company shifts the amount from Current Liabilities to Salary Expense. The account is all clear, and XYZ sends a payslip to the employees as a confirmation of the payment.
Other examples of accrued expenses include office supplies bills, interest on a loan, and income tax. Immaterial expenses like audits and inspections don’t come under the accrued expenses category because they are difficult to track and need back and forth journal entries. Accrued expenses are often confused with accrued revenue, which stands for the money earned in one accounting period but paid for in the next period. In other words, the seller recognized the sell but doesn’t raise an invoice until the next period. Accrued revenues are very rare in the manufacturing world as payment is made once the quote is finalized.
This type of revenue is common in freelancing. For example, a freelance writer is working on a company’s brochure, which has a deadline of 45 days. Before the work begins, the two parties decide that the freelancer will receive $650 for the work. Only after the services are rendered and the 45 days are over, the freelancer can raise the invoice and receive the payment.
In this article, you learned everything about the prepaid expense, which includes what is a prepaid expense, different types, ways to add the expense to the balance sheet, and how to adjust it.
A prepaid expense is an old practice and is known for its two big benefits, which are tax deductions and savings. You also learned the difference between prepaid expense and deferred expense along with the difference between prepaid expense and accrued expense.
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