What Are Prepaid Expenses? Everything You Need To Know

Prepaid expenses include all the bills and financial obligations for products or services for which you pay in advance. Business owners often make recurring payments in advance to avoid any last-minute delays and hassles. 

Doing this also allows businesses to relieve themselves of obligations in future accounting periods. Once paid, you can utilise the goods and services, which makes funds available for other expenses. 

Read on to learn the meaning of prepaid expenditure, how it works, examples, benefits and more. 

Prepaid Expense Meaning

Often, companies pay their bills in advance for the services they will use in the future. These are known as prepaid expenditures or expenses, and you can’t use them within the existing financial period. Generally, people pay in advance for recurring expenses such as rent, insurance, payment for orders, subscriptions, etc. 

How do Prepaid Expenses Work?

Let’s say you paid for any future expense before the due date but can’t use the product or service yet. You will receive the benefits of the service or goods over a period of time. As such, they fall under the assets section.

Then, as and when you receive the benefits of the product or service, the cost will be recorded as an expense. This way, the prepaid expenses would align with the benefit over time. So, as you consume the benefits the amount will get deducted from the advance payment account and added to the expense period. 

Also Read: 6 Ideas to Help Reduce your Expenses

How are Prepaid Expenses Recorded?

According to the Generally Accepted Accounting Principles (GAAP), a company’s balance sheet cannot mention the prepaid expense under immediate expenses. As the expenses do not line up with the benefit incurred, such expenses will become current assets.  

So, the entry for it will be first recorded in assets and cash accounts, where the expenses will be recorded as debit, and the cash account will be credited for the same amount. With time, the amount will get credited from the asset accounts and debited into the expense account. Over time, these entries will cancel each other as the asset value will drop until it reaches zero, and simultaneously, the expense will rise.

In accounting, this adjustment, known as a prepaid expense amortisation, allows you to maintain the balance between credit and debit. 

Example of a Prepaid Expense

To understand prepaid expenses better, consider this example: Let’s say you make a bulk order for material worth ₹15,000 per month. Now, if you wish to pay the bill a year in advance, then you must pay ₹1,80,000 in advance.

Now, you can deduct ₹15,000 from the prepaid amount every month and add it to your monthly expense account entry. At the end of 12 months, your prepaid balance will reach zero, and the total annual expense for ordering material will add up to ₹1,80,000. 

Also Read: Income vs Expenses

Benefit of Prepaid Expenses

Businesses make prepayment for many benefits, some of which are as follow: 

Track Expenses

By making an advance payment, you have the option to easily track the unused amount when asking for refunds. Moreover, you can also calculate the total cost of the product or service and then choose a more pocket-friendly option if available. 

Save More

Often, business partners will give discounts on making bulk or advance payments; this way, prepaid expenditure is a cost-saving solution. Furthermore, in case you don’t have cash outflow in the following month, making advance payments allows you to continue work unrestricted until you get the funds. 

Another benefit of making advanced payments is that it allows you to lock in the current rates. So, if your rent increases or the cost of raw materials rises, you do not have to bear the burden as you have paid in advance. 

Save Tax

Paying in advance allows you to save on taxes, as you can only record the expenses for the year they incurred. Therefore, as per the rule of accounting, you don’t have to pay the taxes for the year when you redeem its benefits. 

Now that you know the meaning of prepaid expenses, their benefits, and entry, you can ensure your operations run smoothly. However, to pay for such assets, you must have cash in hand, which is where Fibe can help you.

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FAQs on Prepaid Expenses

Where are prepaid expenses on the balance sheet?

The record of all prepaid expenses in a balance sheet is under the current asset sections. 

Are prepaid expenses an asset or liability?

You must note all the prepaid expenditures as assets on a balance sheet, as the payments made for goods and services in advance will aid in the future. 

What is the entry of a prepaid expense?

Entry of a prepaid expenditure first comes under assets and cash account, where the asset account will be debited, and the cash account will be credited. Then, as you use the asset (realise the benefit of the expenses), the prepaid expense account gets debited, and the expenses account gets credited. 

Gradually, the funds from the prepaid expense account get transferred to the expense account.