What is a prepaid expense?
A prepaid expense is a type of asset on the balance sheet that results from a business making advance payments for goods or services to be received in the future. Prepaid expenses are initially recorded as assets, but their value is expensed in the income statement over time. Unlike conventional expenses, the business will receive something of value from prepaid expenses over several accounting periods.
Understanding prepaid expenses
Businesses make prepayments for goods or services such as rented office equipment or insurance coverage that provide ongoing benefits over time. Goods or services of this nature cannot be expensed immediately, as the expenses would not correspond to the benefit over time from the use of the asset.
According to generally accepted accounting principles (GAAP), expenses must be recorded in the same accounting period as the benefit generated by the related asset. For example, if a large Xerox machine is rented by a company for a period of twelve months, the company benefits from its use for the entire period. Recording an advance payment made for the lease as an expense during the first month would not adequately correspond to the expenses and income generated by its use. Therefore, it should be recognized as an prepaid expense and charged to expense over the full twelve months.
Journal entries that recognize expenses related to previously recorded prepayments are called adjustment entries. They do not record new business transactions but simply adjust previously recorded transactions. It is necessary to adjust the entries for prepaid expenses to ensure that expenses are recognized in the period in which they are incurred.
Due to the nature of certain goods and services, prepaid expenses will always exist. For example, insurance is a prepaid expense because the purpose of purchasing insurance is to purchase proactive protection in the event something unfortunate happens in the future. Obviously, no insurance company would sell insurance covering an unfortunate event after the fact, so insurance costs must be paid in advance by the companies.
Example of prepaid fees
For example, suppose that ABC has purchased insurance for the next twelve months. He pays $ 120,000 in advance for the insurance policy. ABC will initially recognize the full $ 120,000 as a prepaid insurance debit, an asset on the balance sheet and a cash credit. Each month, an adjustment entry will be charged to $ 10,000 (1/12 of the prepaid amount) in the income statement via a credit to prepaid insurance and a debit to insurance costs. During the twelfth month, the final $ 10,000 will be fully expensed and the prepaid account will be void.