Prepaid Expenses in Accounting

Expenditures are an inevitable aspect of running a business organization. They are incurred by business organizations everyday. Ordinarily, these expenditures are entered in the cash books, their respective accounts (such as rent and power) and in the final account that is prepared at the end of a said accounting period, such as a year, month, or week.

As mentioned, the expenditures that are prepaid are just like normal expenses. However, in case of prepaid expenditures, the expense which is not yet used up is deemed to be the asset of the business organization. It must be noted that prepaid expenses are also known as deferrals, which literally means 'to a future date'. Here's a simpler explanation.

Prepaid expenses are the expenditures that are not yet incurred by the business organization but have been already paid for. In certain cases, they are also defined as payments made against goods to be received in near future. The concept of these expenditures is not universally applicable, that is, not all expenditures can become prepaid expenditures.

The scope of expenditures which can be prepaid in nature, or can become prepaid, is quite narrow or restricted. Rent, power bill, taxes, stationery and certain fixed assets can become prepaid expenditures. Prepaid expenses are eventually expected to get over, upon which, they are recorded in the profit and loss account of the final account.

In the initial stages, the expenditure is recorded into three accounts, the first one is the cash book plus the cash flow statement, which indicates the payment of prepaid expenditure. The next entry is made into the respective account such as rent or tax.

Next off, the prepaid expenditure is entered into the final account. In such cases, the total payment is utilized where the amount that is relevant is shown on the debit side of the profit and loss account. The remaining amount which is to be used up is shown on the asset side of the balance sheet.

For example, a firm pays $4,000 as prepaid tax, including tax for current year. In such a scenario, $1,000 is shown on the debit side of the profit and loss account. The remaining $3,000 is transferred to the balance sheet as the assets of the firm. The prepaid expenses have a significant importance in the formal balance sheet analysis.

Within the balance sheet, the assets are divided into fixed assets, current assets, and advances. The prepaid expenses which are depicted as assets are shown in all three heads. All fixed assets are, in a way, prepaid expenditures, as the actual expenditures arise out of depreciation of the assets, which takes annually. Real estate is, however, an exception.

Secondly, the current assets are prepaid expenses, such as tax and rent, which actually gets used up or rather 'paid' after a certain number of years. Thirdly, there are advances or credits that are provided to other enterprises or, in some cases, a certain fund is advanced to other firms/suppliers/dealers for long-term ease of trade.

In certain cases where the prepaid expenses are significant in volume, a balance sheet is attached to the cash flow statements or other financial statements.

While deriving the available equity, the prepaid expenditures are not included as they are not realizable, that is, they cannot be sold off. The total net worth is however evaluated taking into consideration the total of all prepaid expenditures.