What are Prepaid Expenses in Financial Accounting?
Learn all about Prepaid Expenses in Financial Accounting - Definition, Example.
As the term prepaid itself implies that it is the cost or amount of money that has been paid in advance. It can be considered future expenses, mainly because the sum of money paid is neither used nor expired. Here we are going to see all about prepaid expenses accounting.
Prepaid expenses are not expired; hence the company mentions the expenses on its balance sheet. The balance sheet aims to cover all the unexpired costs and expenses of a particular company or a business.
The assets stored by the companies in the form of prepaid are usually done to make sure that they can get future benefits out of it. Prepaid expenses are not for long-term purposes as they expire after a certain period of time, and after businesses have consumed the amount that is saved as an asset.
Ways in Which the Prepaid Expense Can be Accounted
The prepaid expense can be termed either as an expense or as an asset depending on how different businesses want it to be stored. The way the prepaid money would be treated is different in both cases.
If prepaid money is stored as an expense that after a particular accounting time ends, the expense amount decided for that particular period should remain in that account. The rest of the amount or the future expense can be either debited to the prepaid asset account of that company, or it can be transferred to the other expense account that is dealing with all the future expenses.
However, if the prepaid money is stored as an asset, then the expired portion of the asset should be removed so that the portion that is still valid remains in the account and can be used by companies whenever they are in need.
Prepaid Expenses can be Beneficial.
Businesses use prepaid expenses mainly to earn benefit out of the money that is paid in advance. It tends to protect people from anything unfortunate that might happen over time. Insurance is a form of prepaid expense, as people tend to buy protection of valuable belongings like a car, house, etc. if anything bad might happen.
A certain amount of money would be stored in the insurance account to complete your payment. Every month a certain amount of money would be deducted until the money fully reaches zero.
Businesses who have to make many investments to expand their business often carry prepaid expenses whenever they can. The number of prepaid expenses continues to increase until the amount reaches a point that can be used by the companies to their advantage on the balance sheet.
Risks Involved in Prepaid Expenses
However, everything has two sides to it. It can be negative or positive, or it can be both. The same is the case with prepaid expenses as companies that are making advance payments in prepaid expenses. If they tend to increase it every month, it will impact the company's overall functioning as the cash flow and working capital would be decreased.
It might affect the amount of income generated with the help of working capital. In contrast, a decrease in the number of prepaid expenses would increase the cash flow. It is a two-way system; hence, people have to be careful in deciding the amount they are willing to decide as a prepaid expense.
Businesses and companies should examine their cash flow and other immediate expenses before deciding to increase their prepaid expense every month or every year.
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