Estimated reading time: 11 minutes
On the surface of it, it seems like it should be pretty simple to keep your books as a business owner. After all, you’re really just keeping track of your income and expenses.
But once you realize the importance of accrual-based accounting, there are some complications that can arise.
One such complication is in the treatment of prepaid expenses. Thanks to the GAAP matching principle, it’s necessary to record the expenses on the income statement only when the expense is actually incurred.
For example, if you prepay $12,000 for a year of rent in January, it would be improper and inaccurate to record $12,000 of Rent Expense in January, and no rent the rest of the year. Instead, you would need to reflect that $1,000 of rent was incurred each month throughout the year.
In contrast, if you had recorded the $12,000 as an expense in January itself, you would be showing a huge expense in one month and none in the following months, which is not reflective of your actual situation. Therefore, recording prepaid expenses appropriately makes an accurate, logical depiction of your financial position, especially with respect to your costs and profits which in turn, aids in prudent decision-making.
However the process can appear a bit daunting to begin with. Therefore, this post aims to shed some light on exactly how to record prepaid expenses in your books according to Generally Accepted Accounting Principles.
How Prepaid Expenses Appear on Your Financial Statements
Continuing with the rental example above, you have paid $12,000 in January for 12 months of rent.
However, the matching principle stipulates that you cannot record this entire amount immediately as an expense on your income statement, because you haven’t actually incurred all those costs yet. Instead, accounting rules require you to spread that cost over the period for which you have pre-paid.
The question is, where does that money show up, then? In double-entry accounting, debits and credits always have to be balanced. If $12,000 is being credited to cash, $12,000 needs to be debited somewhere else. The answer lies in the balance sheet — specifically, the asset column.
Just like your bank accounts or your office equipment, prepaid rent is an asset — it is something of value that your business holds. The essential difference is that prepaid expenses are future expenses that have been paid in advance and its benefit can be obtained only in the future. Therefore, these expenses are treated as an asset until the benefit of the expense is realized.
It can seem strange to think of an expense as an asset, but in the case of prepaid expenses that’s exactly what they are. Remember, an asset is defined as something that holds economic value and can be converted into cash or used to generate income. Your prepaid rent, in this case, is an economic resource that will bring benefit to your business over time, and therefore it is indeed an asset.
More specifically, it is a current asset, since the value will generally be recognized within 12 months.
Getting the Prepaid Expense onto the Balance Sheet
So now the question is, how to get the prepaid expense onto the balance sheet?
Firstly in whatever bookkeeping software you use, you’ll create a current asset account called something like “Prepaid Expenses” or “Prepaid Rent” (to go along with this example).
Then when you make the initial purchase, you’ll simply credit your cash account (which of course could be any bank account that your business uses), and debit the Prepaid Expenses account for the same amount. This transaction shows that you’ve spent some money, and in exchange you now have another asset on the books.
After the above transaction, you will have $12,000 less in cash, and a $12,000 asset sitting on your balance sheet.
Notice how no monetary value actually left the business. It was simply converted from one type of asset to another.
Amortizing the Prepaid Expense Over Its Life
Now that we have the prepaid expense on the balance sheet, it needs to be gradually moved from the balance sheet to the income statement as an expense over its useful life, which is the period of time that you’re benefiting from it. This process is called amortization.
To continue with our previous example, you have prepaid $12,000 for a year’s rent, or $1,000 per month. Therefore, at the end of each month, you will debit your Rent Expense account for $1,000 and correspondingly make a credit of the same amount in your Prepaid Rent account. The journal entries would look something like this:
By performing these transactions monthly, we are incrementally moving the prepaid expense from the balance sheet to the income statement. This process appropriately matches the expense with the period it covers, aligning with the accounting principle of matching revenues and expenses in the correct period. It is important to remember that these entries will not impact your cash balance, since the cash was paid at the initial point of rent payment.
Following this procedure, at the end of the 12 month period, the full $12,000 would have been moved from the “Prepaid Rent” account to the “Rent Expense” account. On the balance sheet, the “Prepaid Rent” account would then be at zero, accurately reflecting that there’s no more prepaid rent left to expense. On the income statement, the “Rent Expense” would show the total $12,000 spent on rent throughout the year, accurately reflecting the rent costs incurred.
Handling Long-Term Prepaid Expenses
I said above that a prepaid expense is a current asset, because it is generally expected to be consumed within the next 12 months. However, sometimes you might prepay for something that lasts longer than this. For instance, you might prepay for a three-year software license.
This has to be handled differently, because a current asset is typically something that gets used up in one year or less. Any asset expected to last longer than a year is considered a long-term asset.
In these cases, the portion of the prepaid expense that will be used up within the year remains a current asset, while the portion that extends beyond a year becomes a long-term asset.
Expanding on the example of a three-year software license, if the cost was $4,500, only $1,500 of that could be recorded as a current asset on your balance sheet. The remaining $3,000 would go onto your balance sheet as a long-term asset under “Long-Term Prepaid Expenses” or a similar account.
Note that this is different from purchasing a fixed asset that depreciates over time. When you purchase a fixed asset, like a piece of equipment or a vehicle, you are purchasing an item that has a physical presence and has a useful life span longer than a year. Over time, this asset loses its value due to factors such as wear and tear, obsolescence, and age, therefore, this loss in value is recorded through depreciation.
But this is different from a prepaid expense in that the prepaid expense doesn’t depreciate in value. Instead, its value is gradually realized or consumed over the contract period. In other words, depreciation applies to the declining usefulness of a physical asset, whereas amortization of a prepaid expense applies to the gradual distribution of a cost over a specified period. A physical asset (like a piece of equipment) is still owned by the company after the depreciation period, even if its value diminishes, while a prepaid service or expense will no longer hold any value to the business once it has been fully used or expired.
How to Record Long-Term Prepaid Expenses in the Books
When recording a long-term prepaid expense, you would follow a similar process to short-term prepaid expenses. Let’s continue with the software license example where you prepaid $4,500 for a three-year license.
The Initial Purchase
Once again, you would credit Cash the total of the prepayment, which is $4,500.
However, only $1,500 can be debited as a current asset to the “Prepaid Expenses” account. The remaining $3,000 should be debited to the “Long-term Prepaid Expenses” account, which is a long-term asset account. Your initial journal entry would look like this:
|Long-term Prepaid Expenses
After this transaction, you will have $4,500 less in cash, $1,500 in the Prepaid Expenses account, and $3,000 in the Long-term Prepaid Expenses account.
Amortizing the Expense Over Its Life
Over the three years, you would amortize the expenses onto the income statement just as you would any other prepaid expense. This would be done by making monthly debits to your “Software License Expense” account and corresponding credits to the “Prepaid Expenses” account and “Long-term Prepaid Expenses” account.
Every month, you would deduct 1/36th of the total, or $125, from the “Prepaid Expenses” Account. For instance, the journal entry for the end of January would look like this:
|Software License Expense
Managing the Balance of the Current Asset Account
But there are several things to keep in mind.
You’ll notice that if we deduct $125 from Prepaid Expenses every month, but Prepaid Expenses only contains $1,500, this account will be exhausted in only 12 months.
But here’s the thing: the Prepaid Expenses current asset account should always contain the amount of the prepaid expense that will be used up within the next 12 months. Since the prepaid expense is three years in length, there will always be a portion of it that falls within the next 12 months, until the start of the third year, when the entire remaining balance falls into the 12-month timeframe.
What I mean is this: in February, 2023, Prepaid Expenses should contain the portion of the expense from February, 2023 through January, 2024 (12 months). In March, 2023, Prepaid Expenses should contain the portion of the expense from March, 2023 through February, 2024 (12 months), and so on. This continues in this way until January, 2025, when the entire remaining balance falls into the next 12 months, at which point all the remaining balance will be contained in the Prepaid Expenses account and it will finally begin to be depleted.
So that means that through January, 2025, Prepaid Expenses should always contain $1,500.
The Role of the Long-Term Prepaid Expenses Account
But if we’re constantly crediting $125 every month for the software license, how do we ensure that $1,500 balance? This is where the “Long-term Prepaid Expenses” account comes in.
Long-Term Prepaid Expenses should always contain the portion of the prepaid expense that will not be used up within the next 12 months.
So every month, when you take out $125 from the “Prepaid Expenses” account, you’ll add it back in from the “Long-term Prepaid Expenses” account in order to keep the balances accurate.
Here’s what that entry would look like:
|Long-term Prepaid Expenses
By transferring between the two accounts this way, you are effectively maintaining an up-to-date status of those accounts proportional to the balance of the prepaid expense that falls within the next 12 months, and the balance that falls outside that period.
Finally, starting from January, 2025, all remaining balances of the software license prepaid expense will fall into the 12-month horizon. At this point, your entries will solely involve debiting the software license expense and crediting the prepaid expenses account until the account is completely depleted. The long-term prepaid expenses account will remain at zero from this point forward, accurately reflecting there is no outstanding balance expected to be used up beyond 12 months.
Summarizing the Process
So, in summary, each month for the first two years, you would record two entries:
- A debit to the “Software License Expense” account and a credit to the “Prepaid Expenses” account to record the portion of the prepaid expense that is being used up.
- A debit to the “Prepaid Expenses” account and a credit to the “Long-term Prepaid Expenses” account to refill the current portion of the prepaid expense.
In the third year, you would only record one entry: a debit to the “Software License Expense” account and a credit to the “Prepaid Expenses” account to record the portion of the prepaid expense that is being used up. At the end of the third year, both the Prepaid Expenses and the Long-term Prepaid Expenses accounts will be zero, reflecting that all the prepaid expense has been used.
Here’s what the balances of these two accounts would look like over that three-year period:
Hopefully I was able to demystify the process of recording prepaid expenses, both short-term and long-term. By recording prepaid expenses in this way, you are able to adhere to the matching principle which is key in accrual accounting, and prevent sudden large expenses from distorting the company’s financial performance. This ensures a smooth portrayal of the company’s finances and allows for sensible decision making.
Overall, the accounting for prepaid expenses may seem complex, but once you understand the concept and how the entries work, it becomes fairly straightforward.
If you find yourself struggling, don’t hesitate to reach out for help. As a professional bookkeeper and certified QuickBooks ProAdvisor, I can assist you with keeping track of your prepaid expenses and any other financial management tasks you might require. It’s always important to make sure that these activities are properly accounted for, as it can significantly influence your financial statements and the overall understanding of your business’s financial health. You’re already doing the hard work of running a business. Let me provide the support you need to ensure your financial records are accurate and easily understandable.