Prepaid Expenses: Meaning, Benefits, and Examples

Expenses are any costs incurred by a company or an individual to earn money or use a product or service. Expenses such as supplies, wages, buildings, utilities, rent, equipment, and cars are all paid for by organizations. Some expenses are paid after purchasing an item or service, while others are paid in advance. Such expenses that are paid in advance are called prepaid expenses.

A prepaid expense is one sort of business expense that occurs when a corporation pays for a service or items in advance. Knowing how to record these costs can help keep accounting records up to date. In this article, we’ll look at what a prepaid expense is and some common prepaid expense examples.

A prepaid expense is an asset to the balance sheet. It emerges from a company making advance payments for goods or services that will be delivered in the future. They are represented as assets at first, but their value is expensed onto the income statement over time, as and when the company generates the underlying benefit. Unlike traditional expenses, prepaid expense provides benefits to the company throughout numerous accounting periods. Let’s understand what prepaid expenses are.

Prepaid Expenses: Things to Know

Companies make prepayments for items or services that give ongoing benefits over time, such as leased office equipment or insurance coverage. This type of item or service cannot be expensed right away since the cost would not match the benefit derived over time from using the asset.

The amount of prepaid expenses that will be spent within a year is typically shown as a current asset on a company’s balance sheet. The current asset lowers when the amount expires. The difference is shown as an expense on the income statement.In fact, prepaid expenses journal entries reflect expenses connected to previously recorded ones. They don’t create new business transactions; instead, they make changes to those that have already been recorded. To guarantee that expenses are recognized in the period in which they are spent, adjustment entries for prepaid expenses are required.

Example

Company X signs a one-year lease on a warehouse for Rs.10,000 a month. The landlord requires that company X pays the annual amount (Rs. 1,20,000) upfront at the beginning of the year.

The initial journal entry for company X would be:

At the month-end, company X would’ve completed one month of its lease agreement. The prepaid rent must be adjusted

Prepaid expenses will always exist due to the nature of certain commodities and services. Insurance, for example, is a prepaid expense because the goal of obtaining insurance is to purchase preemptive protection in the event of a future calamity. Because no insurance provider would sell insurance that covers an unfortunate event after it has occurred, firms must pay for insurance up front.

How to Record Prepaid Expenses?

Prepaid expenses are typically recorded in the accounting period in which the benefits of the transaction are realized. If the service or product is provided over a period of time, the cost will be spread out over the period in which the benefit is achieved. Since the service or product has not yet been obtained, the initial prepaid expenses entry will usually have no impact on a company’s financial statements. The asset account is expensed and reduced as the benefit of the expense is realized.

• Make a payment for the expense that was prepaid.
• To reflect the payment made for a prepaid expense, make a basic entry in the general accounting journal.
• Debit the asset account for the amount paid and deduct the same amount from the cash account when initially entering the prepaid expense item.
• Expense this percentage on the income statement at the end of each accounting period that your company benefits from the prepaid service or product.
• Follow the steps above until the benefit or service from the prepaid expense is completely obtained.

Benefits of Prepaid Expenses

Individuals and corporations alike gain from prepaid expenses. Here’s how they can be beneficial.

• Prepaid expenses are those that are purchased or paid for ahead of time. These include insurance, rent, utilities, subscriptions, etc.
• Prepaid expenses allow individuals to ensure that they do not miss payments for essential things like health insurance.
• Many organizations prepay part of their future expenses if they need more business deductions.

Examples of Prepaid Expenses

Let’s understand the meaning of prepaid expenses through a few examples.

Example #1

ABC Company signs a one-year lease at a monthly rent of Rs. 50,000. The landlord requests that the business pay the entire year’s rent in advance. This means ABC Company pays the landlord a prepaid payment of Rs. 6,00,000 to cover the lease for the following 12 months. This prepaid expense will be recorded as a debit in ABC Company’s prepaid rent account and a credit in its cash account at first.

The corporation will have spent one month’s rent payment by the end of the first month. The corporation enters Rs. 50,000 as a rent expense (debit) and Rs. 50,000 as a credit in the prepaid rent account on its books. This is something the company does every month. At the end of 12 months, the prepaid rent will be Rs. 0.

Example #2

On 31.3.2022, Company A pays Mr B an advance salary to cover his medical costs for the following six months. Mr B’s monthly salary is Rs. 50,000.

If Company A publishes its Annual Financial Statement as of March 31, 2022, they will record Rs. 50,000*6= Rs. 3,00,000 as Advance Salary paid to Mr B under the heading “Prepaid Expenses“, and it will be shown in the Balance Sheet under Other Current Assets.

Example #3

Insurance is a great example of prepaid expenses as it is usually paid for ahead of time. If a corporation pays Rs. 1,20,000 for a 12-month insurance policy, it will record a current asset of Rs. 1,20,000 at the moment of payment to represent the prepaid amount. The corporation would record an expense of Rs. 1,00,000 for each month of the 12-month policy and deduct the same amount from the prepaid asset.

The Final Word

Prepaid expenses are company expenses that are paid in advance but for which the benefit will be received in future years. These prepaid expenses are on the balance sheet of the company at the end of the accounting period as current assets. Individuals who prepay expenses ensure that they do not miss payments for things like health insurance. If a company wants to avail of an increased tax deduction, it pays for associated schemes and future expenses in advance.  Yes, the company must adhere to all tax-related regulations and cannot deduct the prepaid expense in the current year.