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.