Prepaid expense definition
/What are Prepaid Expenses?
A prepaid expense is an expenditure that is paid for in one accounting period, but for which the underlying asset will not be entirely consumed until a future period. An example of a prepaid expense is insurance, which is frequently paid in advance for multiple future periods; an entity initially records this expenditure as a prepaid expense, and then charges it to expense over the usage period. Thus, if a company prepays $2,400 of insurance that will cover a one-year period, the initial entry is to the prepaid expense (asset) account, with $200 of this amount being charged to expense in each of the following 12 months, until the entire asset has been consumed.
Accounting for Prepaid Expenses
When a prepaid expense is initially recorded, it is treated as an asset on the balance sheet because it represents a future economic benefit. As time passes and the benefit is used, the prepaid expense is gradually expensed on the income statement. This is done through an adjusting journal entry that moves a portion of the asset to an expense account. For example, if a business pays $12,000 for one year of insurance, it will record $1,000 as an insurance expense each month and reduce the prepaid insurance asset accordingly. This ensures that expenses are matched with the period in which they are incurred, following the matching principle in accrual accounting.
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Prepaid Expense Best Practices
When the amount of a prepaid expense is immaterial, the accountant may choose to immediately charge it to expense. Doing so is more efficient than initially recording it as an asset and then charging it to expense with multiple journal entries over a period of time. This approach is extremely efficient, but will result in a somewhat accelerated recognition of the expense.
Presentation of Prepaid Expenses
A prepaid expense is listed within the current assets section of the balance sheet until the prepaid item is consumed. Once consumption has occurred, the prepaid expense is removed from the balance sheet and is instead reported in that period as an expense on the income statement. If the total ending balance in the prepaid expenses account is quite small, it may be aggregated with other assets and reported within an "other assets" line item on the balance sheet. A sample of the prepaid expense presentation on a balance sheet appears in the following exhibit.
