Is prepaid expense an asset? Oftentimes, businesses incur a type of expense known as a prepaid expense where a company makes advance payment for goods and services. The ability to record these expenses can help in ensuring that accounting books stay up to date. Companies record expenditures as prepaid expenses in order to match their recognition as expenses more closely with the actual periods of their consumption. If a business or company was not to make use of the concept of prepayment, there would somewhat be an understatement of their assets in the short term as well as their profits. The prepaid concept is not used under the cash basis of accounting which smaller organizations commonly use.
In this article, we discuss what a prepaid expense is, whether it is an asset, and its accounting treatment.
What is a prepaid expense?
A prepaid expense is an expenditure paid by a company in one accounting period but for which the underlying asset will be consumed in a future period. In other words, it is a future expense whose payment is made in advance. As the benefits of the underlying assets are realized over time, the amount is then charged to expense. If they are consumed or used over multiple periods, then there may be a series of corresponding charges to expense.
In essence, prepaid expenses represent expenditures that a company is yet to record as an expense but have been paid for in advance. This means that these expenses are paid in one accounting period but are not recognized until a later accounting period.
Oftentimes, companies make prepayments for goods or services such as leased office equipment and insurance coverage that offer continual benefits over time. As payments are made in advance, they have future economic benefits and are expensed at the time when the benefits are realized. This goes in accordance with the matching principle. If goods or services of this nature are expensed immediately, the expenses will not line up with the benefit incurred by the company over time from making use of the asset.
In accordance with the generally accepted accounting principles, expenses are to be recorded in the same accounting period as the benefit generated from the related asset. For example, if a company leases a large copying machine for a period of 12 months, the company derives benefits from its use over the full-time period. Recording the advance payment made for the lease as an expense in the first month will not adequately match the expenses with the revenue generated from its use. It should therefore be recorded as a prepaid expense allocated out to expenses over the full twelve months.
Journal entries that recognize expenses in relation to previously recorded prepaid expenses are called adjusting entries. They do not keep records of new business transactions, they simply adjust transactions that are previously recorded. It is necessary for companies to make adjusting entries for prepaid expenses in order to ensure that expenses are recognized in the period in which they were incurred.
Due to the nature of certain goods and services, prepaid expenses will always be in existence. For example, insurance is a prepaid expense because the aim of purchasing an insurance policy is to buy proactive protection against risks in case an unfavorable event (loss) happens in the future. It is clear that no insurance company will sell insurance that covers an unfortunate event after the fact, so a business must prepay insurance expenses.
What is an asset?
An asset is a resource that an individual or an organization owns which provides economic value. These resources include cash, equipment, rights, property, or anything that helps a company in generating revenue or reduce expenses.
In accordance with International Financial Reporting Standards (IFRS), assets are obtained as a result of past transactions or events and are expected to provide future economic benefits which can be directly or indirectly. For example, one may use a piece of equipment to indirectly generate revenue while cash is a more direct source of value.
Assets are of great importance because they are what businesses make use of to operate and generate a profit. Also, it is one of the three concepts of the fundamental accounting equation alongside liabilities and equity.
See also: Assets, Liabilities, Equity: Comparison
Is prepaid expense an asset?
A prepaid expense is a type of asset on the balance sheet, which is a current asset, as it results from the fact that a business makes advanced payments for goods or services that are to be received in the future. These goods or services that are to be received in the future provide future economic benefits.
Initially, prepaid expenses are recorded as assets, their value is however expensed over time into the income statement. This happens subsequently as a business realizes the benefits of the goods or services over time. Here, the value of the asset will be decreased and the amount will be expensed to the income statement. Unlike conventional expenses, the business will receive something valuable from the prepaid expense over the course of several accounting periods.
In essence, prepaid expenses are considered current assets because they are amounts a business pays in advance in exchange for goods and services that will be delivered in the future. As previously clarified, prepaid expenses usually relate to the purchase of something such as rent or insurance, that provides economic value to the business over several accounting periods, usually six months or a year. So a business records a prepaid expense as an asset on the balance sheet because it is a representation of future economic benefit due to the business.
Under the accrual method of accounting, income is recognized when it is earned while expenses are recognized when they are incurred irrespective of when cash exchanges hands for the transaction. So, it is okay to say that prepaid expenses are an asset because the business is yet to realize the value of the good or service as of the time cash initially exchanges hands.
This can be compared to the mechanics of a depreciation schedule where the actual cash outflow is not recognized in the period an entity incurs the capital expenditure, it is spread across its useful life. Therefore, the prepaid expense asset incrementally declines until the balance eventually gets to zero. At the same time, the expense appears on the income statement in the period that corresponds with the coinciding benefit as the company’s recorded balance decreases.
Accounting for prepaid expenses
As previously stated, prepaid expenses are first recorded on the balance sheet, in the prepaid asset account as it represents future benefits due to the business. They are considered current assets because they are expected to be consumed, used up, or exhausted through standard business operations within the period of one year. However, if a prepaid expense were likely not to be consumed within one year, it would be classified as a long-term asset on the balance sheet instead.
It was previously stated that prepaid expenses are recognized in the income statement as their benefits are realized. Also, they are not initially recorded on the income statement because, in accordance with the GAAP matching principle, expenses cannot be recorded on the income statement before they incur.
With this, it takes the following steps to carry out the basic accounting for a prepaid expense:
- Upon the initial recording of a supplier invoice in the accounting system, it is important to verify that the item meets the company’s criteria for a prepaid expense, asset.
- If the item meets the company’s criteria, it should then be charged to the prepaid expenses account. If on the other hand, it does not, charge the invoiced amount to expenses in the current accounting period.
- The amount of the expenditure should be recorded in the prepaid expenses reconciliation spreadsheet.
- At the end of the accounting period, the number of the period over which the item will be amortized should be established, then this information should be entered into the reconciliation spreadsheet. It is required for this entry to include the straight-line amount of amortization that will be charged in each of the applicable periods.
- At the end of the accounting period, an adjusting entry that amortizes the predetermined amount to the most relevant expense account should be created.
- At the completion of all amortizations, a company should verify that the total in the spreadsheet matches the total balance in the prepaid expenses account. If it does not, then the two have to be reconciled and adjustments are made as necessary.
A best practice is to avoid recording smaller expenditures into the prepaid expenses account since it takes a lot of effort to track them over time. These smaller amounts should rather be charged to expenses as incurred. Furthermore, one should consider charging the remaining balances to expense once they have been amortized down to a certain minimum level. It is critical for both of these actions to be governed by a formal accounting policy that states the threshold at which prepaid expenses are to be charged to expense.
A fertilizer plant signs a 12-month lease on a warehouse for $10,000 monthly. At the beginning of the year, the landlord required this plant to pay $120,000 upfront. The initial journal entry for this company will be as follows:
At the end of the first month, this fertilizer plant would have used up one month of its lease agreement. It is, therefore, necessary to make an adjustment for this prepaid rent as follows:
It is important to note that one month corresponds to $10,000 in rent, that is, $120,000 divided by 12 months. With this, the adjustment on the journal entry will be made each month and at the end of the year, the prepaid balance would be 0 when the lease agreement no longer has any future economic benefits.
Upon signing the one-year lease agreement for the warehouse, the company also makes purchase insurance for the fertilizer warehouse. It then pays $24,000 for a 12-month insurance policy for the warehouse. The initial journal entry for the transaction would be as follows:
Just as it is with the rent, the company would have used up one month of its insurance policy at the end of one month. This would call for an adjustment in the prepaid insurance as represented in the journal entry below:
Also, it should be noted that one month corresponds to $2,000 in the insurance policy, that is $24,000 divided by 12 months.
The company makes the adjusting journal entry each month and at the end of the year. The balance of the prepaid insurance will be equal to when the insurance policy no longer has future economic benefits.
Video: Explaining Prepaid Expense as an Asset
- What is a Free Enterprise Economy? Definition and Examples - January 20, 2023
- What is an Unregulated Market? Definition and Examples - January 16, 2023
- Disadvantages of Free Enterprise Economy - January 16, 2023