Accrual accounting is used today in all organizations to apply the matching accounting principle. This is done primarily to match the income of a given period with the subsequent expenses covered over a certain period of time.
This makes it possible to capture the profitability of the company over time with the necessary accuracy.
In the normal course of business, various transactions occur over time, which is not really consistent with the amount of expenses incurred during that time.
In this case, accountants should separate the expenses into categories of expenses incurred in the current year and expenses to be that are supposed to be carried forward to the next year.
Prepaid expenses and accrued expenses are the two categories of expenses that make up expenses paid over (or under) the amount that was supposed to be paid for the particular year under review.
Prepaid expenses are expenses that an organization paid in advance, while accrued expenses are expenses that the organization owes.
Also Read: How to prepare a balance sheet?
Where are prepaid expenses on balance sheet?
Prepaid expenses make the organization responsible for receiving a certain good or service. This service has already been paid for. Hence, it is recorded as a current asset in the balance sheet.
It can also be considered as an alternative form of money (or cash equivalent), if the amount has been paid to the seller providing this service.
What are Prepaid Expenses?
Also known as down payments, prepaid expenses are expenses that are paid in excess of the amount owed by the business. In view of this, it is important to consider that they include expenses that have already been paid in advance by the company even though they are yet to utilize the product or service.
It is considered as an asset on the balance sheet and comes mainly from companies that make payments in advance.
Prepaid Expenses in Balance Sheet
By definition, an asset is considered an ingenious resource for the organization because it helps to realize short-term profits.
Assets can either be current or non-current (fixed assets). Current assets are short-term assets. They're assets that can provide an incentive to the business within 12 months. They are temporary in nature.
Non-current assets, on the contrary, are long-term investments that can continue to produce profits (or cash flow) for the business for more than 12 months. They are also known as fixed assets and are permanent in nature.
If the business makes an upfront payment to a supplier for a particular good or service, it is an asset. This is because he has already paid for service in full, but the service has not yet been used.
Hence, it is only reasonable to treat it as a current assets until the business provides the corresponding service. Prepaid expenses are treated as a current asset (not a non-current asset) because in most cases the prepaid amount lasts less than 12 months.
However, the depreciation of this asset only occurs after the company uses the aforementioned service. This can be done in a period after the specified year. As the business uses the service offered, the amount gets the expense in the income statement.
In a nutshell, it remains on the balance sheet until it is used (but paid for), after which, having been expensed, it is then reported in the income statement as an expense for the respective year.
How do we record prepaid expenses in the balance sheet?
Prepaid expenses are recorded as a debit to the prepaid expenses account and to the credit of the cash account. When the prepaid item is consumed, an associated expense account is debited and the prepaid expense account is credited.
Difference between Prepaid Expenses and Other Current Assets
As mentioned above, prepaid expenses are shown on the balance sheet as current assets. Other types of current assets include inventories, accounts receivable, cash and cash equivalents.
Prepaid expenses are different from all the different types of current assets because in these existing asset classes, the business is required to receive money (or already has money) for the services provided.
That is to say, prepaid expenses imply that a business is obligated to receive a service (or good) for which it has already paid.
It is therefore clear that the prepaid expenses, although different from other current asset classes, serves the same purpose in providing the desired results.
What Are Examples Of Prepaid Expenses?
There may be several examples of prepaid expenses that are commonly found in a company's balance sheet. Some of these examples are:
1. Prepaid rent: Rent for the coming months which is paid in advance.
2. Prepaid utility bill: Invoice paid in advance for the next few months and not yet posted.
3. Prepaid Insurance: The insurance policy purchased and paid for has not yet been used.
Other examples of prepaid expenses are Rent, equipment paid for before use, salaries, taxes, utility bills, Interest expenses, etc.
Treatment of Prepaid Expenses In Financial Statements
Prepaid expenses can be found on almost all financial statements of various companies. For this reason, it is important to ensure that the treatment of prepaid expenses is strictly respected so that there are no inconsistencies in the preparation of the financial statements.
The financial statements treatment of the most common prepaid expenses is illustrated in the following examples:
1. Treatment of Prepaid Rent
Trendingaccounting LTD acquired new offices for rent on January 1, 2019. According to the agreement with the landlord, they would have to pay a rent advance of 2 years (until December 31, 2020).
The monthly rent was $200 for the rented space, and there was no change to this charge over the two years.
From the example above, it is noticeable that Trendingaccounting LTD paid an upfront fee for the whole of 2020.
Thus, for the year ending December 31, 2019, they had "expensed" a rental fee of $2,400 ($200 * 12). Nevertheless, they also paid an upfront fee for the year ending December 31, 2020.
Thus, the amount of prepaid rent that will be presented in the balance sheet at the end of the year on December 31, 2019 is $2,400. This will be represented as prepaid rent in the current assets.
2. Treatment of Prepaid Insurance
JUSEK Schools pays $6,000 in insurance premium to cover the directors, chairman and all staff of the company. They spend that amount in advance, then adjust each following month to reflect the insurance costs incurred (and prepaid insurance costs).
From the example stated above, it can be seen that when paying $6,000 for prepaid insurance, the following journal entry will be made:
Thereafter, it is important to adjust the item to modify the amount of prepaid insurance at the end of each month and to expense the corresponding amount in the income statement.
Since the annual charge is $ 6,000, the monthly payment for insurance is $500. The adjustment entry for this is as follows:
Following this adjustment entry, the remaining balance of insurance costs amounts to $5,500. This continues to reduce overtime, and for each subsequent month the amount is expensed as the service is used.