Prepaid expenses: an accounting term that deals with timing differences between paying
for something and using it.
This short video covers examples of prepaid expenses in your personal life, in small business,
as well as large publicly listed corporations.
We will also go through the prepaid expenses accounting entries.
Let's make it personal first.
One or more of the following examples of prepaid expenses probably applies to you!
Have you ever put money on a travel card, for use in future travel?
Did you buy a prepaid phone card?
Did you book an airline ticket for your summer holiday?
If so, then you transferred cash prior to using the service you bought.
That's a prepaid expense.
If you check your balance on your London Oyster card, or your New York MTA MetroCard, then
you are looking at the monetary value of the transportation services you have yet to use.
Do you have any other examples of prepaid expenses in your personal life?
Please post them in the comments below this video, as I would love to compile a list of
as many good prepaid expense examples as possible!
Prepaid expenses also apply in the business world.
As a small business owner, I have a subscription to a financial newspaper.
The current subscription period is running from June 1st 2017 to May 31st 2019.
I prepaid 848 Euro and 11 cents (including discount, and excluding VAT) at the start
of the subscription period.
Would it be appropriate to record that full amount as a cost in the income statement in
the year in which I receive and pay the invoice?
No, it would not, as the delivery of the newspapers will be spread over the next 24 months!
A core accounting convention is the matching principle: expenses should be recorded during
the period in which they are incurred.
This is where the balance sheet account of prepaid expenses comes in.
In prepaid expenses, you record the right to receive future services that have already
been paid for but not consumed.
Here's how the journal entries for prepaid expenses work step by step.
We first record the full invoice by crediting cash (money is leaving the company)
and debiting prepaid expenses.
Both cash and prepaid expenses are balance sheet accounts.
Within the asset category, cash goes down and prepaid expenses goes up.
We then have to figure out how to allocate the total amount to the years in which the
service is delivered; when the newspapers are received.
848 Euro and 11 cents for two years or 24 months equates to
roughly 35 Euro and 34 cents per month.
In 2017, June 1st to December 31st is 7 months, so we transfer 7 times 35 Euro from assets
on the balance sheet to cost or expense in the income statement, by crediting
prepaid expenses on the balance sheet and debiting subscription expenses in the income statement.
At the end of 2017, the remaining balance in the prepaid expense account on the balance sheet
represents 17 months' worth of newspapers, around 600 Euro (848 minus the 247 we have now expensed).
In 2018, a full 12 months' worth of newspapers is delivered, hence we transfer half of the
total amount of the invoice, by crediting prepaid expenses on the balance sheet and
debiting subscription expenses in the income statement.
At the end of 2018, the remaining balance in prepaid expenses is 177 Euro:
848 minus 247 minus 424.
The remaining 5 months are booked in 2019, and I will then have to decide whether or
not to renew my subscription.
It is important to check at the end of the subscription period that the full amount of
the original invoice has now been expensed: is the sum of the debits and credits on the
prepaid expenses asset account the same, and the balance therefore zero?
It's not just small businesses that record prepaid expenses, large corporations do it
as well, but with far bigger numbers.
The Coca-Cola Company is one of the Dow Jones 30.
When you look at the balance sheet in their annual report, you will find a line item called
"prepaid expenses and other assets".
In the narrative that discusses the balance sheet accounts, the Coca-Cola Company states
that "prepaid expenses and other assets" includes advance payments to certain customers, for
distribution rights as well as to fund future marketing activities".
The Company expenses such payments over the periods benefited.
Prepaid expenses: a useful accounting concept in your personal life, in small business,
as well as for large publicly listed corporations.
Remember to put your examples in the comments box below this video.
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