Prepaid Expenses

What are “Prepaid Expenses”?

Prepaid expenses represent goods or services that have been paid for upfront and the company expects to use the benefit within 12 months. It is effectively a future expense that a company has paid for in advance. A prepaid expense is only recognized in the income statement when the company consumes the product or service.

Common Reasons for Prepaid Expenses

Many costs associated with running a company require payment in advance. Common examples of this include rent or insurance contracts that have been paid for upfront. The company has the right to occupy the property for the period paid for, and has paid upfront for this, so that it will appear on the balance sheet as a current asset.

In some cases, a company might consume a prepaid expense over multiple periods. This will result in a series of corresponding expenses.

Reporting Prepaid Expenses

Until the expense is consumed, it is treated as a current asset on the balance sheet. As the asset is consumed, it is removed from the balance sheet and expensed through the income statement via retained earnings. This may be done in stages if the reported period is shorter than 12 months. If a company does not consume the prepaid expense within twelve months of payment, it will be reported under long-term or non-current assets.

Who Do Prepaid Expenses Benefit?

Prepaid expenses benefit companies by allowing them to manage their cash flow more effectively. By paying for goods or services upfront, companies can ensure they have access to necessary resources when needed and can avoid potential payment disruptions. Additionally, prepaid expenses can help companies take advantage of any discounts for early payments, and it improves overall financial planning.

Example of Prepaid Expenses

A company has paid its monthly rental of $1,500 at the end of January in advance for the following two months. The effect on the balance sheet through each month is as follows:

Download a free Financial Edge template to look at this example over a longer period.

If we look at this example in more detail we can see that the company doesn’t recognize any of the rent in month 1 – January – the balance sheet simply shows a cash outflow of $3,000 and a prepaid expense of $3,000. This reflects the company’s prepayment of rent for an upcoming period.

After the company expensed February’s rent at the beginning of the month, the prepaid expense account in the balance sheet decreased to $1,500 as $1,500 has been used.

When the company has expensed March’s rent payment at the beginning of that month, it cleared the prepaid expense account.

Below is an extract and breakdown from the Hershey Company Balance Sheet as of December 31.

Extract:

The Hershey Company – Extract from balance sheet

This shows where the Prepaid Expenses can be found on a balance sheet.

More details on exactly what the prepaid expenses include and cover should be available in the notes to the financial statements. These can be either sector-specific, such as pre-paid electricity in some manufacturing companies, or more tailored to the company, which may need to lease office space or decide to prepay certain expenses upfront.

In terms of liquidity, analysts would need to check the footnotes and, if necessary, ask the company if any refunds or repayments can be made on any of the items before usage.

Prepaid Expenses vs. Accrued Expenses

The key difference between these two items is that prepaid expenses are reported in current assets on the balance sheet and accrued expenses as current liabilities. A prepaid expense means a company has made an advance payment for goods or services, which it will use at a future date. Accrued expenses are costs that a company has incurred but has not yet paid by the end of the accounting period. For example, this may be electricity or gas usage if the provider bills the company after the end of the period.

Deferred Expenses vs. Prepaid Expenses

Prepaid expenses represent goods or services paid for upfront where the company expects to use the benefit within 12 months. Deferred expenses, or deferred charges, are long-term assets. They arise when a business pays for goods or services that will be used after 12 months. These expenses are recorded as non-current assets on the balance sheet and are typically consumed over several years. This may include any early tax payments or arrangements made by the company, or longer-term purchasing agreements.

Conclusion

Prepaid expenses play a crucial role in a company’s financial management by allowing businesses to manage their cash flow more effectively and ensure access to necessary resources when needed. By paying for goods or services upfront, companies can avoid potential disruptions, take advantage of discounts for early payments, and improve their financial planning. Understanding the differences between prepaid expenses and other types of expenses, such as accrued and deferred expenses, is essential for accurate financial reporting and strategic decision-making. As companies continue to navigate the complexities of financial management, prepaid expenses will remain a valuable tool for optimizing their operations and achieving long-term success.

Additional Resources

Expenses

Current Assets

Balance Sheet

Current Liabilities