What are “Prepaid Expenses”?
Prepaid expenses represent goods or services paid for upfront where the company expects to use the benefit within 12 months. It is 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.
In some cases, a company might consume the prepaid expense over multiple periods. This will result in a series of corresponding expenses. Common examples include rent or insurance contracts paid for upfront. The company has a right to occupy the property for the period of time paid for.
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. 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.
Key Learning Points
- Prepaid expenses include rent and insurance contracts, and represent goods or services already paid for where the company expects to use the benefit within 12 months
- As they are expected to be used within 12 months they are categorized as a current asset
- Prepaid expenses are reported on the balance sheet and expensed through the income statement via retained earnings as the asset is consumed
- Accrued expenses are a current liability and represent costs a company has incurred but not yet paid by the end of the accounting period
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 is as follows:
Points To Note
- The company recognizes the first expense in February since that was the month of consumption, not January.
- 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.
- When the company expensed March’s rent at the beginning of that month, it cleared the prepaid expense account.
Below is an extract and breakdown from the Hershey Company Balance Sheet at December 31, 2019.
The Hershey Company – Extract from the balance sheet
Prepaid Expenses Versus Accrued Expenses
The key difference is that prepaid expenses are reported as a current asset 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 not yet paid by the end of the accounting period.