Some vendors require their clients to prepay for certain expenses. Other vendors offer discounts on materials or services to customers who are willing to upfront. Individuals and businesses may also independently choose to prepay for expenses in order to get them out of the way and not have to worry about keeping up with regular payments. Here's how to handle prepaid expenses to make bookkeeping easier.
Types of prepaid expenses
When a customer pays for goods or services before receiving them, the costs are considered prepaid expenses. Insurance policy premiums, rental and lease payments, and legal and accounting retainers, are common types of prepaid expenses.
How to treat prepaid expenses
Prepaid expenses are treated as current assets on the balance sheet. A bookkeeper first needs to ensure they have a proper prepaid expense account record to enter the required information. Such prepaid account records are easy to create with cloud-based bookkeeping software, such as Xero and QuickBooks.
At the end of an accounting period, typically monthly, quarterly and yearly, the bookkeeper records the use of the goods and services. They'll do this by debiting the appropriate expense account and crediting the prepaid expense account. Below are four examples of common prepaid expenses and how a business owner accounts for them when doing the books:
Prepaid expense bookkeeping examples
Let's say a company purchases a $2,400 insurance policy in December 2022 for the following year. The policy covers the business from January 1, 2023, until December 31, 2023.
When the bookkeeper is preparing January 2023 month-end journal entries, they debit the “insurance expense” account and credit the “prepaid insurance” account for the amount of insurance coverage used in January 2023, which is $200, as $2,400 per year divided by 12 months is $200 per month.
Let's say a business is offered a 15% discount on office space if it pays the full 12-month lease upfront, rather than a portion each month, for a total of $24,000 including the discount. The business decides to take the 15% discount as it is greater than the business's cost of capital. The bookkeeper then records journal entries of $2,000 for each of the next 12 months to account for the rental expenses, since $24,000 over 12 months is $2,000 per month.
Let's say a business leases a piece of heavy equipment for 3 months to use on a recently won contract. The leasing company requires short-term leases to be paid in full upfront. The business owner pays $30,000 upfront for its use over the next 3 months. At the end of each month, the bookkeeper should record the use of the equipment by debiting the “equipment expense” account and crediting the “prepaid equipment” account.
A legal retainer is a fee that a business prepays for anticipated legal services. Retainers are required by lawyers to ensure that their clients have the ability to pay for their services. A lawyer draws from the prepaid retainer fee when services are provided for the client.
At the end of each month, the lawyer provides a summary of the hours spent and the associated costs of the legal services provided. The business' bookkeeper then takes the costs reported, and creates a journal entry debiting “legal expenses” and crediting “prepaid legal services”.
Need an accountant? Read more about How to Choose a Chartered Accountant in Canada.
A prepaid expense is anything that you pay for before receiving it. The most common prepaid expenses for businesses are insurance premiums and monthly payments for the use of equipment or office space. Yearly gym membership fees are common prepaid expenses for individuals.
Yes, prepaid expenses are considered current assets because the amount of the prepaid expense is intended for future use. All prepaid expenses show up on the business's balance sheet under “current assets”. Each month, bookkeepers should debit the prepaid assets related expenses account and draw down on the prepaid asset account through a credit.
A bookkeeper or business owner needs to create an appropriate current asset account record in her cloud-based bookkeeping software. At the end of each month or reporting period, she should debit the related expense account and credit the prepaid account. This period-ending bookkeeping process continues until the prepaid account balance has been completely drawn down.
There are a few reasons why a business owner would want or need to prepay expenses. Leasing companies often require businesses to fully cover the lease amount upfront due to the value of the equipment being leased. Leasing companies don’t want to risk losing their assets or having to spend time collecting monthly payments. Some companies offer attractive discounts to customers willing to prepay for goods and services.