Prepaid accounting is a common business practice, but it can also be confusing and challenging to manage. In this blog post, we will explain what prepaid accounting is, why it is important, how it works, and how to account for it properly.
What is Prepaid Accounting?
Prepaid accounting is the process of paying for expenses in advance before they are incurred or consumed. These expenses are recorded as assets on the balance sheet because they have future economic benefits. Examples of prepaid expenses include rent, insurance, subscriptions, licenses, and taxes.
Prepaid expenses are also known as prepaid assets because they represent the value of the goods or services that will be received in the future. Prepaid assets are different from prepaid cards or prepaid debit cards, which are payment methods that allow you to spend money that you have already loaded onto the card. Prepaid cards are not considered as assets, because they do not have future economic benefits.
Why is Prepaid Accounting Important?
Prepaid accounting is important for several reasons:
- It helps businesses plan and budget their cash flow, by spreading out large payments over time.
- It helps businesses avoid interest charges, late fees, and penalties, by paying their obligations on time or in advance.
- It helps businesses comply with the matching principle, which states that expenses should be recognized in the same period as the revenues they help generate.
How does Prepaid Accounting Work?
Prepaid accounting involves two main steps: recording and adjusting.
Recording Prepaid Expenses
When a business pays for an expense in advance, it records a debit to a prepaid expense account (an asset) and a credit to a cash account (also an asset). This reduces the cash balance but increases the prepaid expense balance.
For example, suppose a business pays $12,000 for a one-year insurance policy on January 1. The journal entry would be:
Table
| Account | Debit | Credit |
| Prepaid Insurance | $12,000 | |
| Cash | $12,000 |
This journal entry is called a prepaid expense journal entry, and it shows the initial payment for the prepaid expense. The prepaid expense account is also called a prepaid account or a prepaid balance.
Adjusting Prepaid Expenses
As the prepaid expense is used or consumed over time, it needs to be adjusted to reflect the actual expense incurred. This involves a debit to an expense account (an income statement account) and a credit to a prepaid expense account (a balance sheet account). This reduces the prepaid expense balance but increases the expense balance.
For example, suppose the business uses one month of the insurance policy in January. The journal entry at the end of the month would be:
Table
| Account | Debit | Credit |
| Insurance Expense | $1,000 | |
| Prepaid Insurance | $1,000 |
Note that $1,000 is calculated by dividing the total prepaid amount ($12,000) by the number of months in the period (12).
This journal entry is called an adjusting journal entry, and it shows the recognition of the expense in the income statement. The adjusting journal entry is done each month, and at the end of the year, when the prepaid expense has no future economic benefits, the prepaid expense balance would be zero.
The process of reducing the prepaid expense balance and increasing the expense balance over time is called amortization of prepaid expenses or prepaid expense recognition. Amortization means the allocation of the cost of an asset over its useful life.
How to Account for Prepaid Expenses Properly
To account for prepaid expenses properly, businesses need to follow these best practices:
- Identify the prepaid expenses and their periods. For example, a one-year subscription paid in advance is a prepaid expense for 12 months.
- Record the prepaid expenses as assets when they are paid. For example, debit the prepaid expense account and credit the cash account.
- Adjust the prepaid expenses as expenses when they are used or consumed. For example, debit the expense account and credit the prepaid expense account.
- Review the prepaid expense accounts regularly and reconcile them with the actual usage. For example, compare the prepaid insurance balance with the insurance policy terms and make any necessary adjustments.
Some of the common terms and concepts related to prepaid expense accounting are:
- Prepaid rent is rent paid in advance of the rental period. For example, a business may pay six months of rent in advance and record it as a prepaid rent asset. Prepaid rent is amortized over the rental period, and the amortized amount is recognized as rent expense in the income statement.
- Prepaid insurance is insurance paid in advance and that has not yet expired on the date of the balance sheet. For example, a business may pay a one-year insurance premium in advance and record it as a prepaid insurance asset. Prepaid insurance is amortized over the insurance period, and the amortized amount is recognized as insurance expense in the income statement.
- Prepaid service is a service paid in advance that has not yet been rendered on the date of the balance sheet. For example, a business may pay a one-year subscription fee for a software service in advance and record it as a prepaid service asset. Prepaid service is amortized over the service period, and the amortized amount is recognized as service expense in the income statement.
- Prepaid subscription is a subscription paid in advance and that has not yet been fulfilled on the date of the balance sheet. For example, a business may pay a one-year subscription fee for a magazine in advance and record it as a prepaid subscription asset. A prepaid subscription is amortized over the subscription period, and the amortized amount is recognized as subscription expense in the income statement.
- Prepaid liability is a liability that arises when a business receives payment in advance for goods or services that will be delivered or performed in the future. For example, a business may receive a one-year advance payment from a customer for a service contract and record it as a prepaid liability. Prepaid liability is reduced over the service period, and the reduced amount is recognized as revenue in the income statement.
- Deferred expense is another term for prepaid expense, which means an expense that is paid in advance and recorded as an asset until it is used or consumed.
- Unearned revenue is another term for prepaid liability, which means revenue that is received in advance and recorded as a liability until it is earned or delivered.
- Accrued expenses are the opposite of prepaid expenses, which means expenses that are incurred but not yet paid or recorded. For example, a business may incur wage expenses for its employees in December, but pay them in January. Accrued expenses are recorded as liabilities on the balance sheet and as expenses on the income statement.
- Accounting for prepaid expenses is the process of recording, adjusting, and reporting prepaid expenses in the financial statements, following the accounting principles and standards.
- Prepaid expense treatment is the way of classifying and presenting prepaid expenses in the financial statements, depending on their nature and materiality. For example, prepaid expenses may be shown as current assets or non-current assets, depending on their periods. Prepaid expenses may also be shown separately or grouped with other assets, depending on their significance.
- Prepaid expense accounting policy is the set of rules and procedures that a business follows to account for prepaid expenses, based on the accounting standards and regulations. For example, a business may have a prepaid expense accounting policy that defines the criteria, methods, and disclosures for prepaid expenses.
- Prepaid expense allocation is the method of allocating the cost of a prepaid expense over its useful life or period. For example, a business may use the straight-line method or the effective interest method to allocate the cost of a prepaid expense.
- Prepaid expense adjustment is the journal entry that reduces the prepaid expense balance and increases the expense balance, as the prepaid expense is used or consumed. For example, a business may debit the insurance expense account and credit the prepaid insurance account, as the prepaid insurance expires.
- Prepaid expense schedule is a table that shows the details of the prepaid expense transactions, such as the date, amount, period, and balance. For example, a business may prepare a prepaid expense schedule to track and monitor the prepaid expenses and their amortization.
- Prepaid expense calculation is the process of computing the amount of the prepaid expense and its amortization, using formulas and ratios. For example, a business may calculate the prepaid expense amount by multiplying the payment amount by the prepaid expense ratio, which is the fraction of the payment that relates to the future periods.
- Prepaid expense method is the approach or technique that a business uses to account for prepaid expenses, based on the nature and purpose of the prepaid expense. For example, a business may use the cash method or the accrual method to account for prepaid expenses, depending on the timing and recognition of the prepaid expense.
- Prepaid expense reversal is the process of reversing the prepaid expense adjustment when the prepaid expense is no longer valid or applicable. For example, a business may reverse the prepaid expense adjustment
