A:

Prepaid expenses benefit both businesses and individuals. Prepaid expenses are the types of expenses that are bought or paid for in advance. Examples of these are insurance, rent and subscriptions. In general accounting, these are the supplies or services that the company has acquired but has not used during a specified accounting period. As they are consumable supplies and services, they are different from the company's inventory. Unused supplies or services are recorded as assets, while the used or consumed parts of the supplies or services are recorded as expenses. However, in government accounts, they are usually treated under the purchase method. This means that the supply or service is listed as an expenditure instead of an asset.

For individuals, prepaid expenses provide many benefits. On the practical side, for example, it is best to fully pay for a service or product ahead of time, especially if it is an expense that you cannot avoid. For example, if you cannot live without your health insurance, you will want to pay it in advance just to make sure that you will not miss your payment. Another benefit of prepaid expense is savings. One good example is prepaid college plans, or the 529 Plan. A prepaid tuition plan allows you to buy units of tuition in advance. You can pay for several units or one or more semesters of tuition in a college or university of your choice at the present rate. In other words, you will be paying today’s tuition fee rate regardless of when your child attends the university. Considering that tuition fees increase at a rate of 28%, inflation adjusted, if you open a 529 plan ten years before your child goes to college, your savings will be quite significant. It is the same with other prepaid expenses, such as prepaid maintenance costs for cars. The price is locked in, so you avoid the rising cost of the product or service, similar to a 529 plan. Despite the benefits, there are other things to consider before paying in advance, such as whether the company will be able to provide the service or product in the future.

For businesses, prepaid expenses basically offer the same benefits in terms of savings. Aside from savings, there is also the benefit of tax deductions. Many businesses, in fact, prepay some of their future expenses if they need additional business deductions. However, there are various rules as to how you, the business owner, can use your prepaid expenses for tax deductions. One of the basic rules is that you cannot deduct the prepaid expense in the current year. Therefore, if you paid maintenance for your vehicles for five years, you can only deduct a portion of the tax deductible this year and not the entire deduction. Businesses therefore consider the accounting implications of using the prepaid expenses before making the decision to use them in order to take advantage of the tax deductions for the fiscal year.

RELATED FAQS
  1. How are prepaid expenses recorded on an income statement?

    Understand how prepaid expenses are recorded on a company's financial statements. Learn why a prepaid expense would be considered ... Read Answer >>
  2. Can I use a prepaid credit card to pay bills or transfer money to other accounts?

    Learn how prepaid credit cards enable convenient bill payments and transfers. Explore different fees charged for such transactions. Read Answer >>
Related Articles
  1. Managing Wealth

    529 Risks to Take (Or Not)

    Six risks to take into consideration when you're managing the 529 plan that lets you put away tax-advantaged money to help your kids pay for college.
  2. Personal Finance

    6 Reasons You Don't Need A Prepaid Debit Card

    We'll look at six situations where a prepaid debit card might seem like a good idea, but it really isn't necessary.
  3. Financial Advisor

    Using 529 Plans to Save for College

    Paying for college is no easy feat. Here is a lowdown on 529 plans, the educational savings plans that help families set aside funds for college costs.
  4. Retirement

    4 Smart 529 Plan Alternatives to Consider

    Learn about some alternatives to the popular college-saving 529 plan that may also make sense, such as prepaid tuition plans and Coverdell accounts.
  5. Taxes

    10 Tax Benefits for the Self-Employed

    Running your own business has both personal and financial perks.
  6. Small Business

    Writing Off the Expenses of Starting Your Own Business

    Learn how to navigate the complicated rules for writing off the expenses of starting your own business. It could save you a lot of money.
  7. Personal Finance

    Avoid These 3 College Tuition Blunders

    Avoid these big financial blunders when trying to save or pay for college.
  8. Tech

    Top Tax Tips to Deduct Investment Management Fees

    Investment expenses can be deducted by those who meet three main criteria. Here's what they are and how they work.
  9. Taxes

    5 Little-Known Tax Deductions And Credits

    Declaring noncash donations and volunteer work expenditures are just some of the lesser-known ways to reduce your taxes.
  10. Taxes

    An Overview of Itemized Deductions

    Itemized deductions will mostly stay the same for 2017 tax year (medical deductions improve under the new tax bill). Big changes start in 2018.
RELATED TERMS
  1. Prepaid Insurance

    Prepaid insurance payments are made in advance for insurance ...
  2. Prepaid Interest

    Typically determined on a prorated basis, prepaid interest is ...
  3. Prepaid Expense

    A prepaid expense is an asset that arises on a balance sheet ...
  4. Prepaid Tuition Program

    One of the two major types of 529 plans. Prepaid tuition plans ...
  5. Prepaid Cards Processor

    A company that processes transactions for prepaid payment cards. ...
  6. Advertising Costs

    Advertising costs are a category in financial accounting that ...
Hot Definitions
  1. Enterprise Value (EV)

    Enterprise Value (EV) is a measure of a company's total value, often used as a more comprehensive alternative to equity market ...
  2. Relative Strength Index - RSI

    Relative Strength Indicator (RSI) is a technical momentum indicator that compares the magnitude of recent gains to recent ...
  3. Dividend

    A dividend is a distribution of a portion of a company's earnings, decided by the board of directors, to a class of its shareholders.
  4. Inventory Turnover

    Inventory turnover is a ratio showing how many times a company has sold and replaces inventory over a period.
  5. Watchlist

    A watchlist is list of securities being monitored for potential trading or investing opportunities.
  6. Hedge Fund

    A hedge fund is an aggressively managed portfolio of investments that uses leveraged, long, short and derivative positions.
Trading Center