Prepaid expenses are not initially recorded in the income statement. Instead, the prepaid expense is initially recorded on the balance sheet and then, as the benefit of the prepaid expense is realized, or as the expense is incurred, it is recognized in the income statement.
When a business prepays an expense, it is recorded as a prepaid asset on the balance sheet, with a concurrent entry that reduces the business’s cash (or payment account) by the same amount. Most prepaid expenses appear on the balance sheet as a current asset, unless the expense is incurred within 12 months, which is a rarity.
Then, when the expense is incurred, the prepaid expense account is reduced by the amount of the expense and the expense is recognized in the company’s income statement in the period in which it was incurred.
Is insurance considered a prepaid expense?
Insurance, which is usually prepaid, is one of the most common forms of prepaid expenses.For example, ABC Company pays a premium of $ 12,000 for liability insurance for directors and officers for the coming year. The company pays the policy up front and then makes an adjusting entry each month to account for the insurance expenses incurred. The initial entry, where we debit the prepaid expense account and credit the account used to pay the expense, would like this:
Then, after one month, the company makes an adjustment entry for the insurance used. The business debits the appropriate expense account and credits the prepaid expense account to reduce the value of the asset. The monthly adjustment for ABC Company would be $ 12,000 divided by 12 months, or $ 1,000 per month. The adjusting entry at the end of each month would appear as follows:
Rent as a prepaid expense?
Businesses can prepay rent months in advance to get a discount, or maybe the landlord requires prepayment given the tenant’s credit. Either way, let’s assume that Company XYZ prepays office space six months in advance, for a total of $ 24,000. The initial entry is as follows:
Then, at the end of each month, the prepaid rent account, which appears on the balance sheet, is reduced by the monthly rent amount, which is $ 24,000 divided by six months, or $ 4,000 per month. At the same time, the company recognizes a rental expense of $ 4,000 in the income statement. Thus, the monthly adjustment posting would appear as follows:
Other prepaid expenses
Additional expenses that a business can pay up front include interest and taxes. Prepaid interest can occur when a business makes a payment before the due date. Meanwhile, some businesses pay taxes ahead of their due date, such as an estimated tax payment based on what might be owed in the future. Other less common prepaid expenses may include equipment rentals or utilities.
As an example, consider Company Build Inc. which leased a piece of equipment for a construction job. The company paid $ 1,000 on April 1, 2019 to lease a piece of equipment for work that will be done in a month’s time. The company would account for the initial transaction as follows:
Then, when the equipment is in use and the actual expense is incurred, the business makes the following entry to reduce the prepaid asset account and show the rental expense on the income statement:
Whether it is insurance, rent, utilities, or any other prepaid expense, it should be recorded in the appropriate prepaid asset account. Then, at the end of each period, or when the charge is actually incurred, an adjusting entry should be made to reduce the prepaid asset account and recognize (credit) the appropriate income charge, which will then appear. on the income statement.
Why are prepaid expenses not initially shown in the income statement?
Prepaid expenses are not included in the income statement according to generally accepted accounting principles (GAAP). In particular, the GAAP matching principle, which requires accrual accounting. Accrual accounting requires that income and expenses be reported in the same time period as those incurred, regardless of when the money or money changes hands. That is, expenses must be recorded when they are incurred. Thus, prepaid expenses are not recognized in the income statement when they are paid because they have not yet been incurred.