Prepaid Expenses: Meaning, Journal Entry, Examples

Prepaid expenses are technically a financial asset. Companies pay in advance for services or goods they anticipate to receive in the future. They are called assets because it is a commitment that is expected to add to a business's economic value. 

Importance of Managing Prepaid Expenses

Companies must maintain adequate cash flow for prepaid expenses. It is essential for the following reasons:

• Never miss a product or service – Paying upfront for a product or service will ensure that you will not miss out since vendors are obligated to make the supply for those who paid first. 
• Manage rising costs – With prepaid expenses, you will lock in the price of a product or service, which could be affected by varying market conditions. For example, prepaying for fuel expenses will help you manage increasing costs without additional financial stress. 
• Take advantage of tax benefits – Using prepaid expenses, you can bring down tax obligations. You cannot deduct the total prepaid expenses for the current financial year. However, you can defer some amount for other accounting periods. These are considered tax assets to reduce your future taxable income. 

Is Prepaid Expense a Current Asset?

In a company’s balance sheet, prepaid expense is classified as a current asset. This means that it will benefit the business in the future, generally within a year. Prepaid expenses can be made to support standard business operations. 

Prepaid expenses cannot be added to the income statement. As per GAAP (Generally Accepted Accounting Principle), expenses can only be added to the income statement if incurred and utilised in the financial period. 

Prepaid Expenses Journal Entry

In the balance sheet, prepaid expenses are recorded as current assets. When the benefits of prepaid expenses are realised, they can be considered an expense. This reflects the utilisation of prepaid expenses. 

Using this process, the financial statement will reflect both the timing and impact of such expenses. It can be recorded in two ways – asset method and expense method. 

1. Asset method – Here, prepaid expenses are recorded in advance as assets. When the businesses utilise a portion of the prepaid expense, it results in a decrease in prepaid asset value and an increase in expense amount. 
2. Expense method - Prepaid expense is also recorded as assets in advance. However, expense value related to a financial period remains unexpired until that period ends. In the adjustment period, an entry is made under prepaid expense assets.  

Prepaid Expenses Examples

Examples of prepaid expenses for a business include rent, subscription services, or insurance premiums. A company can pay its rent every quarter and realise the benefits for the next quarter. Similarly, insurance premiums paid upfront are expected to offer coverage benefits throughout the year. 

Typically, these represent economic benefits for the future. It is gradually consumed over a period of time, and an adjustment entry is made. With prepaid expenses, its value is not recognised all at once. It is spread over time. 

How are Prepaid Expenses Recorded?

Recording prepaid expenses is an ongoing process. It is first recorded as an asset in balance sheets and accounting books. The expense is not initially entered into the financial statement. 

Over the period when the company realises the benefits of prepaid expense, the expense is allocated in the income statement, and the asset account is updated accordingly in the accounting journal. 

Let's understand the recording of prepaid expenses with an example. 

Sharma Logistics leases a store in Bangalore for a monthly lease of Rs 20,000. The company must pay a full year's lease amount of Rs 2,40,000 per the lease terms. So, the journal entry will be:

Next month, the monthly rental must be deducted from the prepaid rent account. Journal entry should be updated as follows:

The journal must be repeated monthly until the prepaid rent account becomes zero. 

The rental transaction in the account will not be a cash transaction. It is, however, a record in an accounting journal. 

Amortisation of Prepaid Expenses

Amortisation of prepaid expenses is an accounting process where the costs of the prepaid asset are gradually consumed over a time period. In the above example, the prepaid rental expense is amortised over 12 months per the lease agreement. 

So, every month, a portion of the prepaid rent account is recorded as an expense on the income statement for the accounting period. This process continues until the entire value of the prepaid rent account is consumed. 

Amortisation signifies that the prepaid expense is only utilised gradually and not all at once.