Prepaid expenses are payments made for goods or services that will be received in the future. Prepaid expenses are not recorded on an income statement initially. Instead, prepaid expenses are first recorded on the balance sheet; then, as the benefit of the prepaid expense is realized, or as the expense is incurred, it is recognized on the income statement.
- Prepaid expenses are incurred for assets that will be received at a later time.
- Prepaid expenses are first recorded in the prepaid asset account on the balance sheet.
- Unless the prepaid expense will not be incurred within 12 months, it is recorded as a current asset.
- The Generally Accepted Accounting Principles (GAAP) matching principle prevents expenses from being recorded on the income statement before they incur.
- Once expenses incur, the prepaid asset account is reduced and an entry is made to the expense account on the income statement.
- Insurance and rent payments are common prepaid expenses.
When a company prepays for an expense, it is recognized as a prepaid asset on the balance sheet, with a simultaneous entry being recorded that reduces the company's cash (or payment account) by the same amount. Most prepaid expenses appear on the balance sheet as a current asset unless the expense is not to be incurred until after 12 months, which is rare.
Businesses cannot claim a deduction in the current year for prepaid expenses for future years.
Then, when the expense is incurred, the prepaid expense account is reduced by the amount of the expense, and the expense is recognized on the company's income statement in the period when it was incurred.
Insurance As a Prepaid Expense
One of the more common forms of prepaid expenses is insurance, which is usually paid in advance. For example, Company ABC pays a $12,000 premium for directors and officers liability insurance for the upcoming year. The company pays for the policy upfront and then, each month, makes an adjusting entry to account for the insurance expense incurred. The initial entry, where we debit the prepaid expense account and credit the account used to pay for the expense, would look like this:
Then, after a month, the company makes an adjusting entry for the insurance used. The company makes a debit to the appropriate expense account and credits the prepaid expense account to reduce the asset value. The monthly adjustment for Company ABC would be $12,000 divided by 12 months, or $1,000 a month. The adjusting entry at the end of each month would appear as follows:
Rent As a Prepaid Expense
Businesses may prepay rent for months in advance to get a discount, or perhaps the landlord requires a prepayment given the renter’s credit. Either way, let’s say Company XYZ is prepaying for office space for six months in advance, totaling $24,000. The initial entry is as follows:
Then, as each month ends, the prepaid rent balance sheet account is reduced by the monthly rent amount, which is $4,000 per month ($24,000/6 months). At the same time, the company recognizes a rental expense of $4,000 on the income statement. Thus, the monthly adjusting entry would appear as follows:
Other Prepaid Expenses
Additional expenses that a company might prepay for include interest and taxes. Interest paid in advance may arise as a company makes a payment ahead of the due date. Meanwhile, some companies pay taxes before they are due, such as an estimated tax payment based on what might come due in the future. Other less common prepaid expenses might include equipment rental or utilities.
As an example, consider Company Build Inc. which has rented a piece of equipment for a construction job. The company paid $1,000 on April 1, 2019, to rent a piece of equipment for a job that will be done in a month. The company would recognize the initial transaction as follows:
Then, when the equipment is used and the actual expense is incurred, the company would make the following entry to reduce the prepaid asset account and have the rental expense appear on the income statement:
Regardless of whether it’s insurance, rent, utilities, or any other expense that’s paid in advance, it should be recorded in the appropriate prepaid asset account. Then, at the end of each period, or when the expense is incurred, an adjusting entry should be made to reduce the prepaid asset account and recognize (credit) the appropriate income expense, which will then appear on the income statement.
Why Prepaid Expenses Aren’t Initially on the Income Statement
Prepaid expenses aren’t included in the income statement per Generally Accepted Accounting Principles (GAAP). In particular, the GAAP matching principle requires accrual accounting, which stipulates that revenue and expenses must be reported in the same period as incurred no matter when cash or money exchanges hands. That is, expenses should be recorded when incurred. Thus, prepaid expenses aren’t recognized on the income statement when paid because they have yet to be incurred.
In What Section of the Financial Statements Are Prepaid Expenses Recorded?
Prepaid expenses are recorded as assets on the balance sheet. Once realized, the expense is recorded on the income statement.
Why Are Prepaid Expenses an Asset?
Prepaid expenses are classified as assets as they represent goods and services that will be consumed, typically within a year.
What Is the 12-Month Rule for Prepaid Expenses?
The 12-month rule allows taxpayers to deduct prepaid expenses in the current year if the asset does not go beyond 12 months from the date of the payment or the end of the tax year following the year in which the payment was made.
The Bottom Line
At times, payments are made for future benefits. In accounting, these payments or prepaid expenses are recorded as assets on the balance sheet. Once incurred, the asset account is reduced, and the expense is recorded on the income statement. The GAAP matching principle, however, prevents these expenses from being recorded on the income statement before the asset is realized.