Prepaid expenses are defined as costs that an organization anticipates will occur in the future or down the road and are paid ahead of time in advance. It means that it is a cost that has already been paid but not used up as yet.
Meaning of prepaid expenses
A prepaid expense is also considered a type of asset that is shown in the balance sheet of an organisation. It occurs when an individual or a business entity makes an advanced payment for the goods and services that it has not yet received or will receive in the future.
These are no doubt expenses but are initially recorded as assets, and the value is expensed out over time onto the income statement. When the assets are used up, they are naturally recorded as expenses.
There are certain goods and services whose nature demands that it will be used as prepaid expenses. Insurance is known as a prepaid expense as the purpose of an insurance cover is buying proactive protection in case of an adverse situation or mishap.
Do you think that an insurance firm is going to provide you with an insurance benefits scheme after the incident? Of course, not that is why it is an expense that one has to incur beforehand.
As per the modern rules of accounting, the prepaid expenses are advanced payment and must be treated as an asset and hence debit the increase in assets and credit the decrease in expense. The prepaid expense is shown in the financial statements so that any misunderstandings about the understatement of earnings can be avoided in the future. The prepaid expense is also known as
- Expenses paid in advance
- Unexpired expenses
Understanding prepaid expenses
It is a fact that prepaid expenses offer something of value for a few accounting periods. As per the accounting rules, all expenses must be matched with revenues they help in generating, these expenses are not recorded as expenses.
Moreover, the expenses should be recorded in the same accounting period as the benefit generated from the asset. Suppose an office leases a fax machine for twelve months.
The amount is a prepaid expense because it was paid even before the fax machine arrived in the office and the firm will benefit from its usage for the full twelve-month period. It is not feasible to record the advanced payment as an expense in the first month because it then would not match the expense with revenue generated from its use.
This is why it is written as a prepaid expense and gradually allocated out as expense over the full-time period of twelve months.
The adjusting entries instead of recording new business transactions adjust the previous transaction to ensure that the expenses are covered and recognized for the period in which they have occurred.
Examples of prepaid expenses
Few examples of prepaid expenses are monthly, half-yearly or quarterly payments. Costs, for instance, insurance premiums, interest and rent are considered examples of prepaid expenses because they are paid even before incurring.
These are regularly recurring in nature and are phased out in several accounting periods.
Some common examples of prepaid expenses are
- Interest expenses
- Utility bills
- Payment made for the usage of equipment before its use
- Advanced rent for a commercial space
One of the prime examples of a prepaid expense is the insurance premium that a person pays. For example, Ramesh has to pay an amount of Rs 24,000 upfront on 1st April as an insurance cover for his vehicle. The total amount of Rs 24,000 is booked as a debit to prepaid insurance and a credit to cash.
Every month he will have to write an adjusting entry (24000/12 = 2000) as an expense of 2000 to the income statement via credit to prepaid insurance and debit to insurance expense. In the twelve-month, the final 2000 will be fully phased out, and the prepaid account will show a balance of zero.
Advantages of prepaid expenses
Prepaid expenses provide benefits to both individuals and business entities. As per the general accounting rule, the services or supplies that an organization has acquired but not used are consumable services or supplies and are different from the company’s inventory. These unused parts are recorded as assets while the used part as expenses.
If you think from the perspective of an individual, there are several benefits of prepaid expenses for instance-
- If there are some services or products that you cannot avoid at any cost, it is better to pay them upfront. For example, if you have to pay for your rent, then it is better to spend it beforehand so that you do not miss it at any cost. Thus prepaid expenses help in avoiding missed or late payments.
- An essential advantage of prepaid expense is that it helps in savings. There are several plans in place that aids a person to buy them at the current rate. For example, if your son’s university allows paying the fees for the whole period collectively as per today’s rate, then it is savings. We all know that the rate keeps on increasing on an annual basis and if the full amount is paid early, it will help in saving a lot of money. The price is locked in so the individual can easily avoid rising costs
If you think from the perspective of a business entity, there are several benefits of prepaid expenses for instance-
- The prepaid expenses help the business entities in making considerable savings just like it helps the individuals to save a lot of money
- Prepaid expenses result in tax deductions. Mostly, it is seen that if a business entity wants to avail of an increased tax deduction, it generally pays for related schemes and future expenses in advance. Yes, the organization has to follow the proper rules related to tax deductions and cannot deduct the prepaid expense in the current year. Suppose a business has paid rent on its office for three years it can make an adjusting entry for a portion of the tax-deductible in this year and not the entire deduction.
The disadvantages or risks of prepaid expenses are as follows-
- There is always a risk attached if you pay for the full product and services beforehand. What happens if it is not delivered as promised? Suppose a serviceman has promised his services once a month for twelve months and you have paid or it in advance. After seven months, the person stops coming, and you are unable to find him. You have now wasted the services for the next five months ad, in the end, it is a loss.
- Advance payments ultimately decrease the cash flow and working capital that can have a substantial impact on the business.