If you want more consistency in your financial statements, consider the accrual method of accounting to record prepaid expenses. When you originally record the payment of a product or service, put the transaction on a prepaid balance sheet account.
Once you receive the good or service, reduce your prepaid balance sheet account with a credit and increase your expense with a debit. This asset accrues, or accumulates, over a period of time using this method of recording the transaction. This system assumes that you pay for the product or service in advance, receiving it at a later date.
What Are Prepaid Expenses?
Prepaid expenses are expenses you pay for items or services ahead of the time you use or benefit from them. In prepaid expense accounting, these expenses are current assets. They’re assets because you benefit from them in the future, usually within 12 months. If the expenses cover items you receive after 12 months, you consider the expenses as deferred expenses for accounting purposes.
Prepaid Expenses Examples
As you operate your business, three classic examples of prepaid expenses you might encounter are rent, insurance, and subscriptions. Accountants consider prepaid rent as an asset on your financial statements, and prepaid insurance is a current asset, too. With insurance prepayments, you’re buying protection for potential future damage, such as motor vehicle collisions, fires, or floods. Other examples of prepaid expenses you might incur include legal retainer fees, healthcare coverage, property taxes, and maintenance services.
Reaping Benefits of Prepaid Expenses
You might want to prepay an expense when it’s for something you need, you have the money to pay for it, and you don’t want to risk paying a higher price later. Some businesses encourage this by offering discounts for prepayment. These deals happen often with subscriptions to magazines and newspapers, or for services such as couriers or vehicle maintenance. Certain providers of goods and services may require you to prepay some expenses, such as rent and property taxes.
Another reason for prepaying expenses is that you may be able to take them as tax deductions. You should make sure you’re recording your expenses properly, and consult with your accountant about deductions you can take and when to take them.
How Prepaid Expenses Work for Your Business’s Accounting
For example, say you pay $12,000 on January 1 for rent for the entire year. If you expense the payment, the entire $12,000 hits your books in January. However, you have not received the full benefit of this rent for the entire year yet, because rent accrues on a monthly basis. You are only obligated to pay rent one month in advance.
If you put this journal entry to a prepaid account in your financial statements, you spread the $12,000 across all 12 months of the year. By posting the transaction each month and adjusting your prepaid balance, you can recognize $1,000 each month so your rent expense remains consistent.
Why Accrual Accounting Works for Prepaid Expenses
Your accounting entries to reduce your prepaid account involve a debit to your expense account and a credit to your prepaid account on your balance sheet. The debit appears on the left, while the credit appears on the right of the financial statement. This system works because it gives you a more accurate picture of your company’s financial stability. It also gives potential investors a more precise view of your monthly or quarterly financial activity.
Entering prepaid expenses requires you to keep good records. You need to know when the prepaid transaction entered into your records and when it is time to convert it to an expense. Keep reminders or notifications that let you know when it’s time to adjust a prepaid account so you don’t forget to move the balance.
Set up several accounts in QuickBooks, such as prepaid rent, prepaid insurance, or prepaid taxes, instead of using one prepaid account. Then, enter these transactions as specifically as possible when you move the charge to an expense account for those same items.
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