What are the effects of an adjustment for prepaid expenses

Prepaid expenses refer to advance payments for business expenses, while debts owed by a company in the course of its trade are called accounts payable. Each transaction is completely different from the other, but each has a direct effect on the movement of money into or out of a business. Cash-flow problems are a common pitfall of most new entrepreneurs, but knowing how these two transactions can affect your finances can help you avoid a cash shortage.

Increase in Prepayments

1. While making advance payments may seem like a good idea, for many businesses, they may do more harm than good. A healthy cash flow must be able to sustain monthly expenses and inventory purchases, but any increase in prepaid expenses immediately decreases cash flow and working capital. For businesses with marginal cash flow, prepayments can mean less cash to pay for immediate expenses and revenue-generating investments.

Decrease in Prepayments

1. A decrease in prepaid expenses results in an increase in cash flow. Operating expenses are typically paid on a monthly basis, which is why any reduction in prepaid expenses will immediately benefit cash flow for the current month. As an example, reducing the stock of prepaid supplies from three months to one month immediately makes available cash equivalent to two months worth of supplies.

Accounts Payable Increase

1. Accounts payable is considered as current liability if it is payable within a year and as long-term liability if payment will be due in more than a year. Any increase in current, or long-term liability will not affect cash flow since no cash is paid yet at the time the goods or services are acquired.

Accounts Payable Decrease

1. A decrease in accounts payable is a decrease in cash flow. It may be tempting to acquire more goods and services on credit since such transactions do not affect cash flow at the time of purchase. But business owners must keep in mind that subsequent payments will directly reduce cash flow. Improperly managed, accounts payable can accumulate and the resulting monthly obligations can suffocate working capital used to generate income.

Prepaid expenses are future expenses that are paid in advance, such as rent or insurance. On the balance sheet, prepaid expenses are first recorded as an asset. As the benefits of the assets are realized over time, the amount is then recorded as an expense.

Why Are Prepaid Expenses Assets?

Prepaid expenses are considered current assets because they are amounts paid in advance by a business in exchange for goods or services to be delivered in the future. Prepaid expenses usually relate to the purchase of something, such as rent or insurance, that provides value to the business over several accounting periods (often six months or a year). The business records a prepaid expense as an asset on the balance sheet because it represents a future benefit due to the business. As the benefits of the good or service are realized over time, the asset's value is decreased, and the amount is expensed to the income statement. 

What Are the Benefits of Prepaid Expenses?

Sometimes, businesses prepay expenses because they can receive a discount for prepayment. Prepaid expenses may also provide a benefit to a business by relieving the obligation of payment for future accounting periods. There may also be tax benefits concerning prepaid expenses, however, all organizations must follow the proper rules related to tax deductions.

What Is Prepaid Expense Amortization?

Prepaid expense amortization is the method of accounting for the consumption of a prepaid expense over time. This allocation is represented as a prepayment in a current account on the balance sheet of the company.

With amortization, the amount of a common accrual, such as prepaid rent, is gradually reduced to zero, following what is known as an amortization schedule. The expense is then transferred to the profit and loss statement for the period during which the company uses up the accrual.

How Are Prepaid Expenses Recorded?

Prepaid expenses are recorded first on the balance sheet—in the prepaid asset account—because it represents a future benefit due to the business. Prepaid expenses are considered a current asset because they are expected to be consumed, used, or exhausted through standard business operations with one year.

As the benefits of the prepaid expense are realized, it is recognized on the income statement. Prepaid expenses are not initially recorded on the income statement because according to the Generally Accepted Accounting Principles (GAAP) matching principle, expenses cannot be recorded on the income statement before they incur.

Where Do Prepaid Expenses Appear on the Balance Sheet?

Prepaid expenses are first recorded in the prepaid asset account on the balance sheet as a current asset (unless the prepaid expense will not be incurred within 12 months). Once expenses incur, the prepaid asset account is reduced, and an entry is made to the expense account on the income statement.

Examples of Prepaid Expenses

Because of how certain goods and services are sold, most companies will have one or more prepaid expenses. For example, the purpose of insurance is to buy proactive protection for the future. No insurance company would sell insurance that covers a past event, so insurance expenses must be prepaid by businesses.

Here are three common examples of prepaid expenses.

Prepaid Insurance

Insurance is an excellent example of a prepaid expense, as it is always paid for in advance. If a company pays $12,000 for an insurance policy that covers the next 12 months, then it would record a current asset of $12,000 at the time of payment to represent this prepaid amount. In each month of the 12-month policy, the company would recognize an expense of $1,000 and draw down the prepaid asset by this same amount.

Prepaid Rent

Prepaid rent—a lease payment made for a future period—is another common example of a prepaid expense. An organization makes a cash payment to the leasing company, but the rent expense has not yet been incurred, so the company must record the prepaid rent. Prepaid rent is an asset because the prepaid amount can be used in the future to reduce rent expense when incurred.

Retainer for Legal Services

A legalretainer is often required before a lawyer or firm will begin representation. When a company pays a retainer, it is recorded as a prepaid expense on the balance sheet. It’s not expensed immediately because the company has not yet benefited from the services. As future invoices come in, the company would recognize an expense and draw down the prepaid asset by the same amount.

Are Prepaid Expenses Debits or Credits?

When there is a payment that represents a prepayment of an expense, a prepaid account, such as Prepaid Insurance, is debited and the cash account is credited. This records the prepayment as an asset on the company’s balance sheet. An amortization schedule that corresponds to the actual incurring of the prepaid expenses or the consumption schedule for the prepaid asset is also established.

At the end of each accounting period, a journal entry is posted for the expense incurred over that period, according to the schedule. This journal entry credits the prepaid asset account on the balance sheet, such as Prepaid Insurance, and debits an expense account on the income statement, such as Insurance Expense.

Doing so records the incurring of the expense for the period and reduces the prepaid asset by the corresponding amount.

BlackLine Solutions for Prepaid Expenses

BlackLine builds solutions that modernize the finance and accounting function to empower greater productivity and detect accounting errors before they become problems. BlackLine products work in unison to eliminate manual spreadsheet-dependent processes prone to human error. 

BlackLine Account Reconciliations, a full account reconciliation solution, has a prepaid amortization template to automate the process of accounting for prepaid expenses. It stores a schedule of payments for amortizable items and establishes a monthly schedule of the expenses that should be entered over the life of the prepaid items.

The product then automatically amortizes the expense over future periods, eliminating the need to manage spreadsheets or other manual tracking systems. The template also contains an auto-populated roll forward schedule.

BlackLine Journal Entry is a full journal entry management system that integrates with BlackLine Account Reconciliations. It provides an automated solution for the creation, review, approval, and posting of journal entries. This streamlines the remaining steps in the process of accounting for prepaid items.

Together, these tools provide a complete prepaid expense management system.

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Do you ever pay for business goods and services before you use them? If so, these types of purchases require special attention in your books. You need to create a prepaid expenses journal entry.

So, do you know how to record prepaid expenses? Don’t panic if you don’t. Instead, follow this simple guide to recording prepaid expenses to keep your accounting records accurate. 

What are prepaid expenses? 

Prepaid expenses are expenses paid for in advance. You accrue a prepaid expense when you pay for something that you will receive in the near future. Any time you pay for something before using it, you must recognize it through prepaid expenses accounting. 

Prepaid expenses do not provide value right away. Instead, they provide value over time—generally over multiple accounting periods. Because the expense expires as you use it, you can’t expense the entire value of the item immediately. You can only expense the part of the expense you’ve used. Record a prepaid expense in your business financial records and adjust entries as you use the item. 

The process of recording prepaid expenses only takes place in accrual accounting. If you use cash-basis accounting, you only record transactions when money physically changes hands. 

What is considered a prepaid expense? 

Individuals and businesses alike can accrue prepaid expenses. In small business, there are a number of purchases you may make that are considered prepaid expenses.

The following list shows common prepaid expenses examples: 

• Rent (paying for a commercial space before using it)
• Small business insurance policies
• Equipment you pay for before use 
• Salaries (unless you run payroll in arrears)
• Estimated taxes
• Some utility bills
• Interest expenses 

Again, anything that you pay for before using is considered a prepaid expense. 

What type of account is prepaid expense? 

You might be wondering what type of account is a prepaid expense. As a reminder, the main types of accounts are assets, expenses, liabilities, equity, and revenue. 

Maybe you’re thinking … It’s an expense, right? I mean, expense is in the title! Although that’s a fair assumption, it’s not correct.

A prepaid expense is an asset. When you initially record a prepaid expense, record it as an asset. So, where are prepaid expenses recorded? Prepaid expenses in balance sheet are listed as assets, too. 

Prepaid expenses only turn into expenses when you actually use them. As you use the item, decrease the value of the asset. The value of the asset is then replaced with an actual expense recorded on the income statement. 

The bottom line: Before you use a prepaid expense item, it’s an asset. Once the item is used, it is an expense. 

Prepaid expenses journal entry 

Create a prepaid expenses journal entry in your books at the time of purchase, before using the good or service. 

Before diving into the wonderful world of journal entries, you need to understand how each main account is affected by debits and credits.

Assets and expenses are increased by debits and decreased by credits.

On the other hand, liabilities, equity, and revenue are increased by credits and decreased by debits. 

To create your first journal entry for prepaid expenses, debit your Prepaid Expense account. Why? This account is an asset account, and assets are increased by debits. And for every debit, there must also be a credit. Credit the corresponding account you used to make the payment, like a Cash or Checking account. Crediting the account decreases your Cash or Checking account. 

The journal entry you make when you incur the prepaid expense should look like this:

Adjustments for prepaid expenses 

Adjusting entries help balance your books. To recognize prepaid expenses that become actual expenses, use adjusting entries. 

As you use the prepaid item, decrease your Prepaid Expense account and increase your actual Expense account. To do this, debit your Expense account and credit your Prepaid Expense account. This creates a prepaid expense adjusting entry.

Your journal entry reflecting the actual expense should look like this:

Let’s say you prepay six month’s worth of rent, which adds up to $6,000. When you prepay rent, you record the entire $6,000 as an asset on the balance sheet. Each month, you reduce the asset account by the portion you use. You decrease the asset account by $1,000 ($6,000 / 6 months) and record the expense of $1,000.

Repeat the process until the expense is used up. Once you use the prepaid item, the asset account should be empty, and the Expense account should show its full value.

How to record a prepaid expense: Examples 

Prepaid expense journal entries help you keep your accounting books accurate. Let’s look at some examples of prepaid expenses.

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Example 1

Say you buy a one-year insurance policy for your business that costs $1,800. You pay upfront and use the insurance throughout the year.

When you buy the insurance, debit the Prepaid Expense account to show an increase in assets. And, credit the Cash account to show the loss of cash.

Each month, adjust the accounts by the amount of the policy you use. Since the policy lasts one year, divide the total cost of $1,800 by 12. Adjust the accounts by $150 each month.

Expense $150 of the insurance with a debit. Reduce the Prepaid Expense account with a credit. Repeat the process each month until the policy is used and the asset account is empty.

Example 2

You prepay $9,000 of rent for six months. You paid for the space, but you have not used it yet. So, you need to record the amount as a prepaid expense.

First, debit the Prepaid Expense account to show an increase in assets. Also, credit the Cash account to show the loss of cash.

As each month passes, adjust the accounts by the amount of rent you use. Since the prepayment is for six months, divide the total cost by six ($9,000 / 6). Adjust your accounts by $1,500 each month.

Expense $1,500 of the rent with a debit. Reduce the Prepaid Expense account with a credit. Repeat the process each month until the rent is used and the asset account is empty.

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This article has been updated from its original publication date of September 12, 2017.