Prepaid Expense: Definition and Example

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. 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. Thus, prepaid expenses aren’t recognized on the income statement when paid because they have yet to be incurred.

Journal entries that recognize expenses related to previously recorded prepaid expenses are called adjusting entries. They do not record new business transactions but simply adjust previously recorded transactions. Adjusting entries for prepaid expenses is necessary to ensure that expenses are recognized in the period in which they are incurred. As a company realizes its costs, they then transfer them from assets on the balance sheet to expenses on the income statement, decreasing the bottom line (or net income). The advantage here is that expenses are recognized, and net income is decreased, in the time period in which the benefit was realized instead of whenever they happened to be paid.

  • In December, the subscription totals will be accounted for as a deferred expense for Anderson Autos, because the products will not be delivered in the same accounting period they were paid for in.
  • So, ending paints supplies “inventory” is $650 in her professional opinion.
  • Prepaid expenses aren’t included in the income statement per generally accepted accounting principles (GAAP).
  • Debits increase asset or expense accounts and decrease liability, revenue or equity accounts.

Common examples of prepaid expenses include leases, rent, legal retainers, advertising costs, estimated taxes, insurance, salaries, and leased office equipment. Each month, an adjusting entry will be made to expense $10,000 (1/12 of the prepaid amount) to the income statement through a credit to prepaid insurance and a debit to insurance expense. In the 12th month, the final $10,000 will be fully expensed and the prepaid account will be zero.

Examples of Deferred Expenses

A deferral, in accrual accounting, is any account where the income or expense is not recognised until a future date (accounting period), e.g. annuities, charges, taxes, income, etc. The deferred item may be carried, dependent on type of deferral, as either an asset or liability. Understanding deferral in accounting is essential for financial management. From recognizing deferred revenue on your balance sheet to differentiating between deferred revenue and accounts receivable, these concepts are vital for tracking cash flow while staying in line with accounting principles. For instance, if the furniture store were to offer a yearly maintenance service for your new sofa, and you paid the full annual fee upfront, the store would record this as deferred revenue. Although they’ve received the money, they can’t recognize it as revenue until they’ve actually performed the maintenance services over the year.

The adjusting journal entry is done each month, and at the end of the year, when the insurance policy has no future economic benefits, the prepaid insurance balance would be 0. The adjusting journal entry is done each month, and at the end of the year, when the lease agreement has no future economic benefits, the prepaid rent balance would be 0. 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.

Deferred Charge vs. Deferred Revenue

Prepaid expenses are initially recorded as assets, but their value is expensed over time onto the income statement. Unlike conventional expenses, the business will receive something of value from the prepaid expense over the course of several accounting periods. These are both asset accounts and do not increase or decrease a company’s balance sheet. Recall that prepaid expenses are considered an asset because they provide future economic benefits to the company. In December, the subscription totals will be accounted for as a deferred expense for Anderson Autos, because the products will not be delivered in the same accounting period they were paid for in.

The adjusting journal entry for a prepaid expense, however, does affect both a company’s income statement and balance sheet. The adjusting entry on January 31 would result in an expense of $10,000 (rent expense) and a decrease in assets of $10,000 (prepaid rent). Accrual accounting recognizes revenues and expenses as they’re earned or incurred, regardless of when the actual cash is exchanged. For example, if a company provides a service in June but doesn’t receive payment until July, the revenue would still be recorded in June under accrual accounting. Similarly, if the company receives a bill for utilities in June but doesn’t pay it until July, the expense would be recognized in June.

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As each service is provided, a portion of the deferred revenue would be recognized as earned revenue. Imagine you’re a software company, and you’ve just sold a one-year subscription to a customer who pays the entire fee upfront. While you’ve received the money, you haven’t provided the year’s worth of service yet.

It might be easier to think of deferred revenue as “prepaid” revenue. Just as a prepaid expense is an asset that turns into an expense as the benefit is used up, deferred revenue is a liability that turns into income as the promised good or service is delivered. For example, if you have a debt obligation, such as a loan, and you owe $1,000 next month but decide to pay that amount this month, that is a prepayment. A prepaid expense on the other hand is any good or service that you’ve paid for but have not used yet. Current assets are assets that a company plans to use or sell within a year; they are short-term assets. Most often, this is where the prepaid expense line item is recorded.

What are the differences between deferred expenses and prepaid expenses?

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. According to generally accepted accounting principles (GAAP), expenses should be recorded in the same accounting period as the benefit generated from the related asset. For example, if a large copying machine is leased by a company for a period of 12 months, the company benefits from its use over the full-time period. Many purchases a company makes in advance will be categorized under the label of prepaid expense. These prepaid expenses are those a business uses or depletes within a year of purchase, such as insurance, rent, or  taxes.

Financial Accounting

Let’s say MacroAuto buys a bunch of paint on account from SuppliesRUs at the beginning of December. The expense would show up on the income statement while the decrease in prepaid rent of $10,000 would reduce the assets on the balance sheet by $10,000. The two most common uses of prepaid expenses are rent and how long are checks good for insurance. Debits and credits are used in a company’s bookkeeping in order for its books to balance. Debits increase asset or expense accounts and decrease liability, revenue or equity accounts. Deferred revenue is income a company has received for its products or services, but has not yet invoiced for.

Prepaid expense is an accounting line item on a company’s balance sheet that refers to goods and services that have been paid for but not yet incurred. Recording prepaid expenses must be done correctly according to accounting standards. They are first recorded as an asset and then over time expensed onto the income statement.

The initial journal entry for a prepaid expense does not affect a company’s financial statements. The initial journal entry for prepaid rent is a debit to prepaid rent and a credit to cash. Instead, the amount will be classified as a liability on the magazine’s balance sheet. As each month during the subscription term is realized, a monthly total will be added to the sales revenue on the income statement, until the full subscription amount is accounted for. During these same time periods, costs of goods sold will reflect the actual cost amounts to produce the issues that were prepaid.

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