Prepaid expenses are future expenses that have been paid in advance. You can think of prepaid expenses as costs that have been paid but have not yet been used up or have not yet expired.
The amount of prepaid expenses that have not yet expired are reported on a company's balance sheet as an asset. As the amount expires, the asset is reduced and an expenseis recorded for the amount of the reduction. Hence, the balance sheet reports the unexpired costs and the income statement reports the expired costs. The amount reported on the income statement should be the amount that pertains to the time interval shown in the statement's heading.
A common prepaid expense is the six-month premium for insurance on a company's vehicles. Since the insurance company requires payment in advance, the amount paid is often recorded in the current asset account Prepaid Insurance. If the company issues monthly financial statements, its income statement will report Insurance Expense that is one-sixth of the amount paid. The balance in the account Prepaid Insurance will be reduced by the amount that was debited to Insurance Expense.
The balance in the current asset account Prepaid Expenses should be adjusted prior to issuing a company's financial statements. If the company issues financial statements for each calendar month, you will need to adjust the balance in Prepaid Expenses as of the end of each month. If your company issues only quarterly financial statements, you will need to adjust the balance at the end of each quarter.
The goal is to have the balance in Prepaid Expenses be equal to the amount of the unexpired costs as of the end of the accounting period (which is also the date appearing in the heading of the balance sheet).
Usually the adjusting entry for prepaid expenses will be a credit to Prepaid Expenses and a debit to the appropriate expense account(s). For instance, if Prepaid Expenses involve the prepayment of insurance premiums the adjusting entry will include a debit to Insurance Expense.
Generally, expenses are deferred in order to comply with the accounting guideline known as the matching principle.
To illustrate the concept, let's assume that a company pays $3,000 on December 30 to rent a warehouse for the upcoming three-month period of January 1 through March 31. Since none of the $3,000 expires or is used up in December, none of the amount should be reported as rent expense on the income statement for the month of December. Hence the $3,000 is deferred to a balance sheet account such as Prepaid Rent (or Prepaid Expenses), which is a current asset account.
During the three months of January 1 through March 31 (when the prepaid rent is expiring) the $3,000 prepayment must be moved from the balance sheet asset account to an income statement expense account. The usual allocation will involve an adjusting entry to debit Rent Expense for $1,000 and credit Prepaid Rent for $1,000 on January 31, February 28 and March 31.
What are the two methods for recording prepaid expenses?
The two methods for recording prepaid expenses have to do with the general ledger account that is initially debited at the time of the cash payment. The two methods or approaches are:
1. debit an asset account (such as Prepaid Insurance) which is the balance sheet method, or
2. debit an expense account (such as Insurance Expense) which is the income statement method.
The use of either method will almost always require an adjusting entry prior to issuing the company's financial statements. However, the amount, the account that will be debited, and the account that will be credited in the adjusting entry will depend on the method used.
In short, either the balance sheet method or the income statement method for recording prepaid expenses may be used as long as the asset account balance is equal to the unexpired or unused cost as of the balance sheet date.
In theory, the payment in advance for a one-year subscription should initially be recorded as a debit to Prepaid Expenses and a credit to Cash. During the subscription period, you would debit Subscription Expense and would credit Prepaid Expenses.
For example, if the annual subscription cost is $240 and it is paid in advance, you would initially debit Prepaid Expenses for $240 and credit Cash for $240. If your company issues monthly financial statements, then each month during the subscription period you would debit Subscription Expense for $20 and credit Prepaid Expenses for $20. This results in 1) the matching of $20 to expense on each of the monthly income statements, and 2) the balance sheet reporting the amount that is prepaid or not yet expired.
At a large company, the annual cost of $240 will usually be an immaterial amount. The materiality concept will allow you to violate the matching principle, and to avoid the monthly adjusting entry, by simply debiting Subscription Expense for the entire $240 at the beginning of the one-year subscription period.
What are assets?
Assets are sometimes defined as resources or things of value that are owned by a company. Some examples of assets which are obvious and will be reported on a company's balance sheet include: cash, accounts receivable, inventory, investments, land, buildings, and equipment. In addition, a company's balance sheet will also report prepaid expenses as an asset. For instance, if a company is required to pay its rent at the beginning of each quarter (January 1, April 1, etc.) the portion that is prepaid (not used up) as of the balance sheet date will be listed as a current asset.
A company may state that its employees are its most valuable asset. However, the employees cannot be included as an asset on the company's balance sheet. Similarly, a company may have successfully promoted its products, services and brands throughout the world and the brands are now the company's most valuable assets. Yet these brands and trademarks cannot be reported as assets on the company's balance sheet. (If a company purchases a brand from another company, the cost can be listed as an asset on its balance sheet.)
As our examples indicate, the accountant's definition of an asset has to be somewhat complicated in order to:
· include prepaid expenses and deferred costs, and
· exclude a company's talented team, the patents and trademarks that were developed internally, and its image and reputation for excellence at a fair price.
Under the accrual method of accounting, period costs such as selling, general and administrative expenses are reported on the income statement in the accounting period in which they are used up or expire. They are referred to as period costs because they are not assigned to products, and therefore cannot be included in the cost of items held in inventory.
If a selling, general and administrative (SG&A) expense is prepaid, the prepaid portion will be reported as a current asset. When the prepaid expense expires, it will move to the income statement and become part of that period's SG&A expenses.
Interest expense is also a period cost unless it is determined to be a necessary cost of a self-constructed, long-lived asset.