When To Use Prepaid Expenses

What are Prepaid Expenses? Prepaid Expenses are placed into an asset account. The balance in this account rises when payments are made for goods and services that will be used or received in the near future, usually within a 12 month period. Some examples of what could be treated as prepaid expenses are annual memberships, insurance policies, and equipment rentals. The main purpose of using the prepaid expense method is to make sure the expense is recognized on the Income Statement when the service/goods have been used, following accrual accounting principles.

Let’s use company ABC Inc. as an example to help us understand the logic behind using prepaid expenses. Company ABC Inc. purchased its insurance for a total premium of $12,000. The insurance company is requesting $4,000 as a down payment and four other payments in the amount of $2,000, which will total up $12,000. ABC Inc. will be paying $12,000 in insurance expense for coverage of a twelve month period. If ABC Inc. does not use the prepaid insurance expense, it will be expensing the insurance payments on a cash basis as the payments are being made. This can cause discrepancies in the monthly financials; for the first 4 months, there would be a total of $12,000 in insurance expense and no insurance expense for the following 8 months, even though the company is covered for the full twelve months. Adapting a prepaid insurance schedule will allow the Income statement be consistent and accurate. See below for the prepaid expense calculation:

Down payment: $4,000

4 payments of $2,000: $8,000

Total premium: $12,000

The coverage is twelve months, making the monthly expenses $1,000 ($12,000/12 months).

Now that we are aware what our monthly insurance coverage is, in a form of a journal entry and a monthly basis, we can take $1,000 out of the Prepaid Expenses account (Asset) on the Balance Sheet, and put it into the Insurance Expense account (Expense) on the Income Statement.

Accuracy and precision in the financial statements are critical to the success of a business. Using Prepaid Expenses not only provide accuracy in reporting but a clear understanding of true monthly costs and actual company performance.

Written by:
Adriat Markos
TGG Accounting

One Response to When To Use Prepaid Expenses