Companies and businesses perform prepayments for products and services like a leased piece of equipment in the office or insurance coverage that gives continuous benefits over a long period of time. These types of services and products naturally can not be expensed at once as the expense will not match the benefit obtained over time using the given asset. A common example of a prepaid expense is an insurance premium for 6 months which is purchased in advance for the insurance coverage on an organization’s vehicles. The advance payment receipts and invoices are recorded using expense sheets or payment record templates.
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What are the Prepaid Expenses?
Prepaid expenses refer to expenditures that have not yet been documented by an organization as its expense but have already been paid in advance. These expenses are costs that have been paid in one accounting period, however, will not be considered until a given accounting period. Prepaid expenses are recorded assets as they provide economic benefits in the future and are expensed when the company realized its benefits. The prepaid expense reports will be recorded on a company sheet as a current asset and as this asset reduces, the amount of its reduction will be reported as an expense on an income statement.
How to Record Prepaid Expenses
A prepaid expense policy is one of the approaches that companies use to obtain products or services that might deliver benefits to their business in the future. Prepaid expenses are payment performed by companies for services or goods that it has not used yet and is recorded as an asset on the company’s balance sheet. This type of expense benefits the company as it enables it to save money while recording them as tax deductions to comply with the rules on tax deductions.
Step 1: Pay the Prepaid Expense
The first thing you have to make sure of is that you made a payment for your company’s prepaid expense on the company balance sheet. Mark it as an asset as it is the representation of the benefits that your company will be receiving in the future.
Step 2: Include It in the Company’s Accounting Journal
Once you have paid your prepaid expense, include an entry in your company’s general accounting journal to keep a record of the payment you made. This will serve as a piece of evidence that your company has paid for a certain service or product and you are expecting to receive it.
Step 3: Charge on the Asset Account
As you record the first entry for your prepaid expense, debit the account of the asset for the amount paid and subtract that same amount from your company’s cash account. Your company’s overall record for its financial plan will not be affected.
Step 4: Allocate an Expense on the Income Statement
At the end of every accounting period the company receives benefits from the prepaid products and services, expense a part that it has used on the company or business income statement. This will reduce the balance of the prepaid insurance account and will turn it into expenses.
What are the common elements that are included in a company’s prepaid expenses?
A company’s prepaid expense commonly includes their employees’ insurance benefits, other insurance policies related to the company, taxes, interest expenses, salaries, leased office equipment, rent for office space before it is used, bulk purchase orders of supplies, and retainer for legal services.
What are the typical examples of prepaid expenses?
The most common example of prepaid expenses is prepaid insurance which is always paid in advance, prepaid rent which is a lease payment for future use of space, and retainer for legal services which is usually required before a firm or lawyer starts their representation.
What are the effects of a company’s prepaid expenses on its financial statements?
The first journal entries for a prepaid expense will not affect the company’s financial statements. However, the adjusting journal entry for prepaid expenses will affect the company’s income statement and balance sheet.
Prepaid expenses are payments made by a company or organization to purchase goods or services for their future use which means they have yet to receive and use it yet. Companies commonly record this expense as an asset on their balance sheet and are reflected as expenses on the company’s income statement. The prepaid goods and services are benefits that provide value to the company over a certain period of time.
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