Prepaid expenses procedure
/What are Prepaid Expenses?
Prepaid expenses are expenditures that have not yet been consumed, and so are capitalized for a short period of time. They are initially recorded on the balance sheet as current assets, and are later charged to expense. The following procedure shows a consistent way of charging these items to expense.
Examples of Prepaid Expenses
Here are several examples of common prepaid expenses:
Prepaid rent. Prepaid rent occurs when a business pays for its office or facility space in advance of the rental period. This payment is recorded as an asset on the balance sheet and is gradually expensed each month as the space is used.
Prepaid insurance. Businesses often pay insurance premiums upfront to cover risks like property damage or liability for a specific period. This cost is initially recorded as a prepaid expense and expensed monthly to reflect the insurance coverage consumed.
Prepaid advertising. Companies may pay for advertising campaigns ahead of time to secure media slots or promotional packages. The expense is recognized gradually as the ads are run, aligning the cost with the period in which the advertising benefits are received.
Prepaid software licenses. Payments for annual or multi-year software licenses are often made in advance to ensure continuous access. These payments are recorded as prepaid expenses and amortized monthly to reflect the software's usage over time.
Prepaid maintenance contracts. Businesses might pay upfront for maintenance services on equipment or IT systems to ensure uninterrupted support. This prepaid amount is expensed periodically based on the duration of the service agreement.
Prepaid taxes. Some businesses make estimated tax payments in advance to comply with tax regulations or to avoid penalties. These payments are recorded as prepaid expenses and adjusted once the actual tax liability is determined.
Prepaid utilities. In certain cases, businesses might pay utility bills in advance, especially if offered a discount. The prepaid amount is then recognized as an expense as utilities are consumed each month.
Prepaid subscription services. Subscriptions for trade journals, cloud services, or data platforms are often paid annually in advance. These payments are recorded as assets initially and expensed each month to reflect the service's ongoing benefit.
Prepaid legal fees. Businesses might pay legal retainers upfront to secure ongoing legal support. These retainers are recorded as prepaid expenses and expensed progressively as legal services are provided.
Prepaid travel expenses. Payments for airfare, hotel bookings, or conference fees made before the actual travel date are considered prepaid expenses. These costs are recognized as expenses when the travel or event occurs.
In summary, prepaid expenses represent payments made in advance for goods or services that benefit future periods, helping businesses align expenses with the period in which they are actually incurred.
Initial Recognition of Prepaid Expenses
When coding supplier invoices for entry into the accounting system, obtain written approval from the assistant controller that a billing should be coded as a prepaid expense. Otherwise, the default entry is to record an expenditure as a expense.
Verify that the item to be coded as a prepaid expense is equal to or greater than the company's minimum capitalization limit of $______. If not, then charge it to expense in the current period.
Copy the documentation associated with the item and store it in the prepaid expenses binder.
Enter the prepaid item in the prepaid expenses amortization spreadsheet, noting the beginning and ending dates of the amortization period, as well as the amount being capitalized, the name of the supplier, and the invoice number of the source document. Only straight-line amortization is allowed. If the item is not to be amortized yet, then note the reason on the spreadsheet.
Related AccountingTools Courses
Subsequent Amortization of Prepaid Expenses
Verify the amortization calculations on the prepaid expenses amortization spreadsheet.
Take the total amortization from the spreadsheet for the current period and enter it into the standard amortization journal entry.
Have the assistant controller confirm the entry.
Post the amortization entry.
Reconciliation of Prepaid Expenses
At the end of each month, print the detail for the prepaid expenses account.
Match the line items in the account to the supporting detail in the prepaid expenses amortization spreadsheet.
If the supporting detail does not match the account balance, adjust the account balance with the approval of the assistant controller.
Note: If the balance for a prepaid line item falls below a designated minimum level, such as $250, consider writing off the entire remaining balance, thereby eliminating the need to continue tracking the remaining amortization of that item. To minimize the approval work on this, allow the staff to write off remaining balances below $250 without any supervisory approval.