Prepaid Expenses Examples, Accounting for a Prepaid Expense

Almost any expense paid in advance can be considered a prepaid expense. In the coming twelve months, the company recognizes an expense of $2,000/month — which causes the current asset recorded on the balance sheet to decrease by $2,000 per month. Once the benefits of the assets are gradually realized, the current asset is reduced as the asset is expensed on the income statement. Due to the nature of certain goods and services, prepaid expenses will always exist. For example, insurance is a prepaid expense because the purpose of purchasing insurance is to buy proactive protection in case something unfortunate happens in the future. Clearly, no insurance company would sell insurance that covers an unfortunate event after the fact, so insurance expenses must be prepaid by businesses.

• Since this expense is spread over 12 months, through amortization, you would divide the total amount by 12 to calculate your monthly rent, i.e., $1,000.
• Suppose the entity has paid rent for six months and prepares financial statements on a monthly basis.
• The Generally Accepted Accounting Principles matching principle prevents expenses from being recorded on the income statement before they incur.
• The journal entry would be a debit to prepaid insurance for $2,000 and a credit to cash for $2,000.
• BlackLine builds solutions that modernize the finance and accounting function to empower greater productivity and detect accounting errors before they become problems.

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Advantages of Prepaid Expense

This is particularly important if the time frame is less than 12 months. This journal entry is prepaid rent accounting completed to establish your Prepaid Insurance asset account that represents the prepaid amount.

As you can see, if you have multiple prepaid expenses, then this process could easily become overwhelming to keep track of and maintain properly. Your prepaid insurance account will steadily reduce while your insurance expense will increase. Every month, you have to debit the asset account by $2,000 and credit the cash account by $2,000 until you reach the end of the year. Paying upfront can help you avoid the rising cost of goods and services, receive a discount, and take advantage of tax deductions.

What Is the 12-Month Rule for Prepaid Expenses?

Each month, the value of this benefit is recognized when the business decreases its prepaid expense account. As the business enjoys the use of its rental https://www.bookstime.com/ location, it recognizes the benefit by decreasing the prepaid expense account. A prepaid expense refers to future expenses that are paid in advance.

The first step in recording a prepaid expense is the actual purchase of the expense. For example, if you pay your insurance for the upcoming year, you would first pay the expense, making sure to record it properly. The Generally Accepted Accounting Principles matching principle prevents expenses from being recorded on the income statement before they incur. BlackLine and our ecosystem of software and cloud partners work together to transform our joint customers’ finance and accounting processes. Together, we provide innovative solutions that help F&A teams achieve shorter close cycles and better controls, enabling them to drive better decision-making across the company. Whether you’re new to F&A or an experienced professional, sometimes you need a refresher on common finance and accounting terms and their definitions.

Assets, Liabilities, Equity: Comparison

However, once the prepaid rent has been used up, the expense is recorded on the income statement as rent expense. Prepaid rent is not initially recorded on an income statement in accordance with the Generally Accepted Accounting Principles , and as such are not temporary accounts. Therefore, when recording prepaid rent, it is very important to not forget to shift the prepaid rent into an expense account in the exact month that the rent is consumed. If not, the financial statements would under-report the expense and over-report the asset. That is why it is advisable for the bookkeeper to keep track of the contents of the prepaid rent account and review it before closing the books at the end of each month.

Immediately expensing prepaid expenses can cause profits to fluctuate, making performance benchmarking over a period of time difficult. Failure to adjust these expenses accurately leads to the account balance remaining the same, which overstates the value of any prepaid expenses as an asset. Inflated assets can cause problems with budgeting and when it’s time to file taxes.

What Is Accounts Receivable?

It represents those expenses of the company that will provide benefit in the coming accounting period but are paid in advance by the company. These expenses are initially recorded as current assets but benefits of the same will be realized in future years. The most common example is the insurance premium which is paid in the middle of the accounting period for 12 months. Therefore, the same will be recorded in the books of accounts of the company in the accounting year in which it is paid. For example, assume ABC Company purchases insurance for the upcoming 12 month period.

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Also, if a partial benefit is received, only the remaining balance of the prepaid expense appears on the balance sheet. This is because the benefit of the remaining balance is not yet realized. If it were likely not to be consumed within the next 12 months, it would be classified on the balance sheet as a long-term asset. Under the accrual method of accounting, income is recognized when it is earned and expenses are recognized when incurred, regardless of when cash exchanges hands for the transaction. Prepaid expenses are an asset because the business has not realized the value of the good or service when cash initially exchanges hands.

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