Prepaid expenses are payments write out for goods or services that will be received in the future. Prepaid expenses are not recorded on an income statement initially. As opposed to, prepaid expenses are first recorded on the balance sheet; then, as the benefit of the prepaid expense is realized, or as the expense is drew, it is recognized on the income statement.
Key Takeaways
- Prepaid expenses are incurred for assets that will be received at a later point.
- Prepaid expenses are first recorded in the prepaid asset account on the balance sheet.
- Unless the prepaid expense last will and testament not be incurred within 12 months, it is recorded as a current asset.
- The Generally Accepted Accounting Principles (GAAP) equivalent principle prevents expenses from being recorded on the income statement before they incur.
- Once expenses invite, the prepaid asset account is reduced and an entry is made to the expense account on the income statement.
- Insurance and rent payments are worn out prepaid expenses.
Recording Process
When a company prepays for an expense, it is recognized as a prepaid asset on the balance leaf, with a simultaneous entry being recorded that reduces the company’s cash (or payment account) by the same amount. Most prepaid expenses act on the balance sheet as a current asset unless the expense is not to be incurred until after 12 months, which is rare.
Partnerships cannot claim a deduction in the current year for prepaid expenses of future years.
Partnerships cannot claim a deduction in the current year for prepaid expenses of future years.
Then, when the expense is attracted, the prepaid expense account is reduced by the amount of the expense, and the expense is recognized on the company’s income statement in the period when it was incurred.
Is Bond Considered a Prepaid Expense?
One of the more common forms of prepaid expenses is insurance, which is usually paid in deposit. For example, Company ABC pays a $12,000 premium for directors and officers liability insurance for the upcoming year. The company even the scores for the policy upfront and then, each month, makes an adjusting entry to account for the insurance expense incurred. The approve entry, where we debit the prepaid expense account and credit the account used to pay for the expense, would look match this:
Then, after a month, the company makes an adjusting entry for the indemnification used. The company makes a debit to the appropriate expense account and credits the prepaid expense account to reduce the asset value. The monthly adjusting for Company ABC would be $12,000 divided by 12 months, or $1,000 a month. The adjusting entry at the end of each month make appear as follows:
Rent as a Prepaid Expense
Businesses may prepay rent for months in accelerate to get a discount, or perhaps the landlord requires a prepayment given the renter’s credit. Either way, let’s say Company XYZ is prepaying for office leeway for six months in advance, totaling $24,000. The initial entry is as follows:
Then, as each month ends, the prepaid slit balance sheet account is reduced by the monthly rent amount, which is $4,000 per month ($24,000/6 months). At the despite the fact time, the company recognizes a rental expense of $4,000 on the income statement. Thus, the monthly adjusting entry would arrive as follows:
Other Prepaid Expenses
Additional expenses that a company effect prepay for include interest and taxes. Interest paid in advance may arise as a company makes a payment ahead of the due rendezvous. Meanwhile, some companies pay taxes before they are due, such as an estimated tax payment based on what might be stricken due in the future. Other less common prepaid expenses might include equipment rental or utilities.
As an example, weigh Company Build Inc. which has rented a piece of equipment for a construction job. The company paid $1,000 on April 1, 2019, to fee a piece of equipment for a job that will be done in a month. The company would recognize the initial transaction as follows:
Then, when the equipment is used and the actual expense is incurred, the company would turn into the following entry to reduce the prepaid asset account and have the rental expense appear on the income statement:
Regardless of whether it’s insurance, rent, utilities, or any other expense that’s paid in push, it should be recorded in the appropriate prepaid asset account. Then, at the end of each period, or when the expense is incurred, an adjusting coming should be made to reduce the prepaid asset account and recognize (credit) the appropriate income expense, which leave then appear on the income statement.
Why Prepaid Expenses Aren’t Initially on the Income Statement
Prepaid expenses aren’t counted in the income statement per Generally Accepted Accounting Principles (GAAP). In particular, the GAAP matching principle requires accrual accounting, which warrants that revenue and expenses must be reported in the same period as incurred no matter when cash or money interchanges hands. That is, expenses should be recorded when incurred. Thus, prepaid expenses aren’t recognized on the proceeds statement when paid because they have yet to be incurred.
In What Section of the Financial Statements Are Prepaid Expenses Recorded?
Prepaid expenses are recorded as assets on the balance sheet. Once realized, the expense is recorded on the income statement.
Why Are Prepaid Expenses an Asset?
Prepaid expenses are classified as assets as they mirror goods and services that will be consumed, typically within a year.
What Is the 12-Month Rule for Prepaid Expenses?
The 12-month decide allows taxpayers to deduct prepaid expenses in the current year if the asset does not go beyond 12 months from the lover of the payment or the end of the tax year following the year in which the payment was made.
The Bottom Line
At times, payments are made for following benefits. In accounting, these payments or prepaid expenses are recorded as assets on the balance sheet. Once incurred, the asset account is decreased, and the expense is recorded on the income statement. The GAAP matching principle, however, prevents these expenses from being accounted on the income statement before the asset is realized..