Prepaid expenses, sometimes called prepayment are future expenses that the business pay in advance before it actually benefited from the product or service. For example, in the course of business operations, landlords usually ask for rent payment in advance say 2 years at the beginning of the lease term. Another typical example of prepaid expenses are insurance, subscription etc.
Prepaid expenses are usually treated as current assets on the balance sheet until the time the costs are incurred or terms of the payment have expired. In other words, a 5 year prepaid expenses will be charged to the income statement on monthly or annual basis usually in equal amounts. The amount on the balance sheet should be equals to the portion that is yet be incurred or benefitted by the firm.
How does Prepaid Expenses affect the firm?
General accounting principle requires that the revenue earned should be matched to the cost that are incurred to generate the revenue. It is this reason prepaid expenses are carried forward to match the revenue which they will generate in future. When expenses are incurred but not yet paid (accrued), they should be added to the expenses on the income statement and recognised as current liabilities on the balance sheet.
Prepaid expenses can affect the firm in two ways namely the net cash flow and income statement. Let use a simple case study to explain this point in detail.
Case Study: KBC Prepaid Rent
KBC ltd paid rent for 5 years (i.e. 60 months) of D600,000 to the landlord on 01-Jan-2015, how will this impact on the cash flow and income statement?
3. Income Statement Effect: If KBC recognized this entire payment as expenses in Jan 2015, it’s income statement will not accurately reflect the true nature of the rent cost in 2015. Remember that Jan 2015 is just one month out of the entire 5 years contract.
To properly account for this prepaid rent, the firm has to divide the D600,000 by the number of months, in this case 60 months. This will equals D10,000 per month. At the close of each month, an entry of D10,000 is made to rent expense on the income statement and reduce the prepaid expenses by the D10,000 on the balance sheet. The firm will do this every month until the end of Dec 2019 when the prepaid amount will be fully expired. This process of spreading the cost of a prepaid expenses is sometimes called amortization.
You can download our free Excel template – Prepaid expenses amortization file
2. Cash Flow Effect: KBC Ltd will record cash outflow of D600,000 by increasing the prepaid expenses ( debit) and reduce cash and bank balances ( credit). This confirms that prepaid expenses if material can lead to a major cash out flow from the business bank account. And anything that can lead to major cash out flow should always be checked by business managers and owners.
In conclusion, it important for small businesses and startups to stimulate the impact of prepaid expenses before committing to the relevant agreement. While the total prepaid expenses will not charged to the income statement in one accounting period, prepayments can affect the cash flows of the firm. If a major prepaid expenses is not properly managed it can affect the firm’s liquidity.