Prepayments and Prepaid Expenses

Prepayments and Prepaid Expenses

Prepayments are the payment of a bill, operating expense, or non-operating expense that settle an account before it becomes due. Learn the concept of prepaid expenses. Understand the accounting treatment for prepaid expenses. Understand the concept by looking at some practical examples and finally learn the adjusting entry for these expenses. 

What are Prepaid Expenses?

Prepaid expenses, sometimes referred to as deferred expenses, are the amounts that have been paid in advance to a vendor or creditor for goods and services. These payments initially get recorded as assets but are expected to become expenses over time or through the normal operations of the business. Supplies, prepaid insurance, prepaid advertising, advance rental, advance tuition fee, and prepaid interest are some examples of prepaid expenses that may require adjustment at the end of an accounting period.

What is the accounting treatment for prepaid expenses?

Prepaid Expenses are the expenses that are paid before the time period in which the benefit will be consumed. The payment is a current asset on the balance sheet and this amount paid is then amortized, as the consumption or utilization happens by charging proportionate amounts to expense accounts. Because the advance payments are to obtain benefits for the organization over a period of time, the cost of these assets is charged against profits throughout the period, usually on a monthly basis. Prepaid expenses are treated as current assets because the company has paid for something and someone owes services or goods in exchange in the future.

Although the prepaid expenses are generally classified as Current Assets in the balance sheet, however, it’s an unusual classification as prepaid expenses will never, except in rare cases, be turned into cash in the practical world. Prepaid expenses are expenses that have been paid in advance and therefore won't have to be paid again, in a way they create cash by enabling the company to avoid paying out towards the expense for the benefit period.

What are some examples of Prepaid Expenses?

Every business buys insurance of various kinds to manage and mitigate risk and to buy insurance the organization needs to pay the premium to the insurance company, which is generally paid in advance, typically for a year at a time, and covers the organization for specified risks for the policy period. For some businesses, insurance can be a very costly item. The policy cover may extend many accounting periods and hence companies allocate the cost of that protection over the period of time that is being protected, based on the allocation per accounting period. Proper accounting treatment, matching, and accrual concepts demand that the premium benefits all 12 months and should therefore be charged to profits over the benefit period, not just the month in which you paid the premium.

So, if the company has defined its accounting period as a calendar month and the policy period is for 12 months, then the company will charge the insurance amount to expense over the 12 months that it protects, usually by simply charging 1/12 of the total to expense each month. The balance of the advance premium payment is considered prepaid and it rests in a prepaid expense account until it has been entirely written off to expense. Other examples of prepaid expenses might be property taxes, advance rentals, or advance income tax installments.

Adjusting Entry for Prepaid Expenses:

Prepaid expenses (or deferred expenses) are expenses paid in cash and recorded as assets prior to being used. The most common form of an adjusting entry for prepaid expenses would be to create a current asset at the time of payment for the expense and charge it to the expense account over the accounting periods for which the benefit will be in place. These types of adjusting entries are usually permanent.

In the case of prepaid expenses, there is a timing difference between the cash-flow and the actual charge to the expense spread over the period of coverage of the advance. In case these cash-flows are not matched to the accounting periods in which the expenses will actually happen, it will adversely affect the profits of the period in which the cash flow has been recorded. Therefore prepaid expenses are treated as assets to reflect the true state of affairs for the current accounting period.

Many business managers often overlook these timing differences because they think that the effects will equal and compensate each other over time. But such differences can be very significant in the short term and can impact the critical cash flow planning.

Prepayment accounting entries:

Given below is a set of accounting entries that generally take place in automated systems and ERPs:

Step 1: Raise a Prepayment Invoice

Debit: Prepaid Expense A/c

Credit: Liability A/c

(Example: Performa invoice of the total insurance period for the year has been received and the company has decided to purchase the policy)

Step 2: Prepayment is release to the vendor:

Debit: Liability A/c

Credit: Bank/cash A/c

(Example: The payment has been released to the vendor)

Step 3: When the Invoice is raised for Expense:

Debit: Expense Charge A/c

Credit: Prepaid Expense A/c

(Example: During the accounting period one, the charge for the expense is made and prepaid expense is reduced by the same amount)

Related Links

Creation Date Tuesday, 30 November -0001 Hits 43214

You May Also Like

  • Divisional Organizational Structures

    Divisional Organizational Structures

    The divisional structure or product structure consists of self-contained divisions. A division is a collection of functions which produce a product. It also utilizes a plan to compete and operate as a separate business or profit center. Divisional structure is based on external or internal parameters like product /customer segment/ geographical location etc.

  • GL - Intercompany Accounting

    GL - Intercompany Accounting

    After reading this article the learner should be able to understand the meaning of intercompany and different types of intercompany transactions that can occur. Understand why intercompany transactions are addressed when preparing consolidated financial statements, differentiate between upstream and downstream intercompany transactions, and understand the concept of intercompany reconciliations.

  • Five Core General Ledger Accounts

    Five Core General Ledger Accounts

    Typically, the accounts of the general ledger are sorted into five categories within a chart of accounts. Double-entry accounting uses five and only five account types to record all the transactions that can possibly be recorded in any accounting system. These five accounts are the basis for any accounting system, whether it is a manual or an automated accounting system. These five categories are assets, liabilities, owner's equity, revenue, and expenses.

  • The Accounting Process

    The Accounting Process

    In this article we will focus on and understand the accounting process which enables the accounting system to provide the necessary information to business stakeholders. We will deep dive into each of the steps of accounting and will understand how to identify accounting transactions and the process for recording accounting information and transactions.

  • Complexities in GL System

    Complexities in GL System

    Although technically a general ledger appears to be fairly simple compared to other processes, in large organizations, the general ledger has to provide many functionalities and it becomes considerably large and complex. Modern business organizations are complex, run multiple products and service lines, leveraging a large number of registered legal entities, and have varied reporting needs. 

  • Record to Report Process

    Record to Report Process

    Record to report (R2R) is a finance and accounting management process that involves collecting, processing, analyzing, validating, organizing, and finally reporting accurate financial data. R2R process provides strategic, financial, and operational feedback on the performance of the organization to inform management and external stakeholders. R2R process also covers the steps involved in preparing and reporting on the overall accounts. 

  • Team-Based Organizational Structure

    Team-Based Organizational Structure

    Team-based structure is a relatively new structure that opposes the traditional hierarchical structure and it slowly gaining acceptance in the corporate world. In such a structure, employees come together as team in order to fulfill their tasks that serve a common goal.

  • General Ledger Process Flow

    General Ledger Process Flow

    In this article, we will explain the general Ledger journal processing flow from entering journals to running the final financial reports. Understand the generic general ledger process flow as it happens in automated ERP systems. The accounting cycle explains the flow of converting raw accounting data to financial information whereas general ledger process flow explains how journals flow in the system.

  • GL - Journal Posting and Balances

    GL - Journal Posting and Balances

    In this tutorial, we will explain what we mean by the posting process and what are the major differences between the posting process in the manual accounting system compared to the automated accounting systems and ERPs. This article also explains how posting also happens in subsidiary ledgers and subsequently that information is again posted to the general ledger.

  • Concept of Foreign Branches

    Concept of Foreign Branches

    As the business grows, the company may want to transition to a branch structure as branches are allowed to conduct a much broader range of activity than representative offices. Branches can buy and sell goods, sign contracts, build things, render services, and generally everything that a regular business can do.  A company expands its business by opening up its branch offices in various parts of the country as well as in other countries.

Explore Our Free Training Articles or
Sign Up to Start With Our eLearning Courses

Subscribe to Our Newsletter


© 2023 TechnoFunc, All Rights Reserved