Expenses are any cost that a business or individual incurs. They may be required to generate revenue or to consume a product or service. Entities pay money for expenses such as supplies, wages, facilities, utilities, rent, and equipment and vehicles. For corporations, expenses are part of the cost of doing business, while individuals incur expenses as part of their cost of living.
Some expenses are paid after a good or service is incurred, while others are paid in advance. The latter are called prepaid expenses. This article takes a brief look at prepaid expenses along with who stands to benefit from these kinds of costs.
- Prepaid expenses are expenses that are bought or paid for in advance, and may include things like insurance, rent, utilities, and subscriptions.
- Individuals benefit from prepaid expenses to make sure they will not miss payments for things like health insurance.
- Many companies prepay some of their future expenses if they need additional business deductions.
What are Prepaid Expenses?
Prepaid expenses are expenses that are bought or paid for in advance, and may include things like insurance, rent, utilities, and subscriptions. In general accounting, these are supplies or services that the company has acquired but has not used during a specified accounting period.
As they are consumable supplies and services, prepaid expenses are different from a 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 the supply or service is listed as an expenditure instead of an asset.
Who do Prepaid Expenses Benefit?
Prepaid expenses benefit both individuals and businesses. Here's a look at how prepaid expenses work for both entities.
Benefits for Individuals
For individuals, prepaid expenses provide many benefits. On the practical side, it is best to fully pay for a service or product ahead of time, especially if it is an expense you cannot avoid. For example, if you cannot live without health insurance, you will want to pay for 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 a prepaid college plan 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 pay today’s tuition fee rate regardless of when your child attends the university. Considering that tuition fees increase at an alarming rate—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.
Benefits for Businesses
Prepaid expenses basically offer the same benefits for businesses 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 the business owner can use prepaid expenses for tax deductions.
One of the basic rules is that the business cannot deduct the prepaid expense in the current year. Therefore, if you pay 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.
Corporations consider the accounting implications of using a prepaid expense before deciding to use them in order to take advantage of the tax deductions.
Reporting Prepaid Expenses
Businesses may have different methods of reporting prepaid expenses on their balance sheets. Companies generally carry a prepaid expense on their balance sheets and designate them as current assets. That is until they are fully consumed. If the product or service in question is used over a period of time, businesses may make several charges to their expense accounts.