How to Account for Prepaid Expenses
Familiarize yourself with accrual-based accounting., Learn the definition of pre-paid expenses., Familiarize yourself with the link between accrual accounting and pre-paid expenses.
Step-by-Step Guide
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Step 1: Familiarize yourself with accrual-based accounting.
In order to understand the accounting for pre-paid expenses, it is important to understand the basic principle of accrual-based accounting.
Quite simply, in accrual-based accounting, revenues are reported on the income statement when they are earned, not when the cash is received.
For example, if you provide a service worth $1,000 in June, and do not receive the cash for the service until August, the income will be reported on the income statement as $1,000 of revenues in June.
In August, the income statement would show no revenues (assuming there were no other revenues from the business).
This is because you earned the revenues in June.
This differs from cash-based accounting, whereby the revenues are recorded when the cash itself is provided, not when the revenues are earned. -
Step 2: Learn the definition of pre-paid expenses.
A pre-paid expense is simply a future expense that is paid for in advance.
Typically, it involves an expenditure during one accounting period, followed by the consumption of whatever the pre-payment was for, over multiple periods.
Common examples of pre-paid expenses include insurance premiums, rent, and any business contracts that require payment in advance.
For example, with insurance, you may pay your premium six months in advance (which is common).
Then, over a period of six months, that premium will be "used". , Accrual accounting requires that revenues be recognized in the period for which they are earned (not when cash is paid out), and the same principle applies to expenses.
Expenses, in the same way, are not recognized when cash is paid out (or when the pre-paid expense is paid for), and are rather recognized over time as the thing that was pre-paid is used.As an example, if you are paying rent six months in advance, the pre-paid expense would not be recorded in the month when you send the check to the landlord.
Rather, the expense would be recorded over the six month period as the expense is "used up".
In this case, every month for the six month period, one sixth of the total rent amount will appear on the income statement.
Something known as the matching principle is what governs the treatment of prepaid expenses.
This principle dictates that expenses should be recorded when the associated goods or services have been used, not when they are paid for, so that the expense matches the revenues that the expense helped to earn. -
Step 3: Familiarize yourself with the link between accrual accounting and pre-paid expenses.
Detailed Guide
In order to understand the accounting for pre-paid expenses, it is important to understand the basic principle of accrual-based accounting.
Quite simply, in accrual-based accounting, revenues are reported on the income statement when they are earned, not when the cash is received.
For example, if you provide a service worth $1,000 in June, and do not receive the cash for the service until August, the income will be reported on the income statement as $1,000 of revenues in June.
In August, the income statement would show no revenues (assuming there were no other revenues from the business).
This is because you earned the revenues in June.
This differs from cash-based accounting, whereby the revenues are recorded when the cash itself is provided, not when the revenues are earned.
A pre-paid expense is simply a future expense that is paid for in advance.
Typically, it involves an expenditure during one accounting period, followed by the consumption of whatever the pre-payment was for, over multiple periods.
Common examples of pre-paid expenses include insurance premiums, rent, and any business contracts that require payment in advance.
For example, with insurance, you may pay your premium six months in advance (which is common).
Then, over a period of six months, that premium will be "used". , Accrual accounting requires that revenues be recognized in the period for which they are earned (not when cash is paid out), and the same principle applies to expenses.
Expenses, in the same way, are not recognized when cash is paid out (or when the pre-paid expense is paid for), and are rather recognized over time as the thing that was pre-paid is used.As an example, if you are paying rent six months in advance, the pre-paid expense would not be recorded in the month when you send the check to the landlord.
Rather, the expense would be recorded over the six month period as the expense is "used up".
In this case, every month for the six month period, one sixth of the total rent amount will appear on the income statement.
Something known as the matching principle is what governs the treatment of prepaid expenses.
This principle dictates that expenses should be recorded when the associated goods or services have been used, not when they are paid for, so that the expense matches the revenues that the expense helped to earn.
About the Author
Robert Lane
Specializes in breaking down complex home improvement topics into simple steps.
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