How are prepaid expenses recorded in the income statement?

Prepaid expenses are not initially recorded in an income statement. Instead, prepaid expenses are initially recorded on the balance sheet, and then, as the benefit of the prepaid expense is realized, or when the expense is incurred, it is recognized in the income statement.

When a company prepays an expense, it is recorded as a prepaid asset on the balance sheet, with a concurrent entry that reduces the company’s cash (or payment account) by the same amount. Most prepaid expenses appear on the balance sheet as a current asset, unless the expense is only due after 12 months, which is a rarity.

Then, when the expense is incurred, the prepaid expense account is reduced by the amount of the expense, and the expense is recognized in the company’s income statement in the period it was incurred.

Is insurance considered a prepaid expense?

One of the most common forms of prepaid expenses is directors’ and officers’ liability insurance for the upcoming year. The company pays for the policy in advance, then each month makes an adjusting entry to account for the insurance costs incurred. The initial entry, where we debit the prepaid expense account and credit the account used to pay the expense, would like this:

Then, after one month, the company makes an adjusting entry for the insurance used. The company debits the appropriate expense account and credits the prepaid expense account to reduce the value of the asset. The monthly adjustment for ABC Company would be $12,000 divided by 12 months, or $1,000 per month. The adjusting entry at the end of each month would appear as follows:

Rent as a prepaid expense?

Businesses may prepay rent for months in advance to get a discount, or perhaps the landlord requires prepayment given the tenant’s credit. In any case, let’s say Company XYZ prepays office space six months in advance, for a total of $24,000. The initial entry is as follows:

Then, at the end of each month, the prepaid rent account, which appears on the balance sheet, is reduced by the monthly rent amount, which is $24,000 divided by six months, or $4,000 per month. At the same time, the company recognizes a rental charge of $4,000 in the income statement. Thus, the monthly adjusting entry would appear as follows:

Other prepaid expenses

Additional expenses a business might prepay include interest and taxes. Prepaid interest can arise when a company makes a payment before the due date. Meanwhile, some companies pay taxes before they are due, as an estimated tax payment based on what might come due in the future. Other less common prepaid expenses may include equipment rentals or utilities.

Take the example of Company Build Inc. which rented equipment for a construction job. The company paid $1,000 on April 1, 2019, to rent equipment for work that will be done in a month. The company would acknowledge the original transaction as follows:

Then, when the equipment is used and the actual expense is incurred, the company makes the following entry to reduce the prepaid asset account and show the rental expense in the income statement:

Whether it is insurance, rent, utilities, or any other prepaid expense, it should be recorded in the appropriate prepaid asset account. Then, at the end of each period, or when the expense is actually incurred, an adjusting entry should be made to reduce the prepaid asset account and post (credit) the appropriate revenue charge, which will then appear in the account. of result.

Why are prepaid expenses not initially shown in the income statement?

Prepaid expenses are not included in the statement of earnings under generally accepted accounting principles (GAAP). In particular, the GAAP matching principle requires accrual accounting. Accrual accounting requires income and expenses to be reported over the same period as incurred, regardless of when cash or money exchanges are exchanged. In other words, expenses should be recorded when incurred. Thus, prepaid expenses are not recognized in the income statement when they are paid, because they have not yet been incurred.