Prepaid expenses are not recorded at the beginning of the income statement. Instead, prepaid expenses are initially recorded on the balance sheet and then recognized on the income statement when the benefits of the prepaid expenses are realized or the expense is incurred. 1
When a company prepays an expense, it is recognized on the prepaid balance sheet on that date, along with an entry that reduces the company’s cash (or payment account) by the same amount. Most prepaid expenses appear on the balance sheet as current assets unless the expense is incurred after 12 months, which is a rare situation.
Then, as the expense is incurred, the prepaid expense account is reduced by the amount of the expense, which is charged to the company’s income statement as it occurs.
Is insurance an upfront fee?
A common form of prepaid expenses is that insurance is usually paid in advance. 1 For example, ABC Corporation pays $12,000 in premiums for directors and officers’ liability insurance for the upcoming year. The company pays the insurance premium first and then makes an adjustment entry once a month to include the insurance expense incurred. The initial entry, where we debit the prepaid expense account and credit the account used to pay the expense, looks like this:
Then, one month later, the company makes an adjusting entry for the insurance used. The company makes a business debit to the corresponding expense account and credits the prepaid expense account to reduce asset values. ABC’s monthly adjustment is $12,000 divided by 12 months or $1,000 per month. The adjusting entries at the end of each month are as follows:
Businesses can prepay rent months in advance to get a discount, or landlords may ask for early repayments given the tenant’s credit. Either way, let’s say Company XYZ prepays for office space six months in advance, totaling $24,000. The initial entries are as follows:
Then, at the end of each month, the prepaid rent account on the balance sheet is reduced by the monthly rent amount ($24,000 divided by 6 months, or $4,000 per month). At the same time, the company recognized a lease expense of $4,000 on the income statement. Therefore, the monthly adjusting entries are as follows:
Other deferred expenses
Additional fees that companies may prepay include interest and taxes. Early payment interest may accrue when the company pays before the due date. At the same time, some companies pay taxes before they are due, such as estimated tax payments based on amounts that may be due in the future. Other less common upfront costs might include equipment rental or utility bills.
As an example, consider the company Build Inc., which rents a piece of equipment for a construction job. The company paid $1,000 on April 1, 2019, to rent a piece of equipment for work done within a month. The Company confirms the initial transaction as follows:
Then, when the equipment is used and the actual expense is incurred, the Company will make the following entry to reduce the prepaid asset account and charge the lease expense to the income statement:
Whether it is insurance, rent, utilities, or any other prepaid expenses, it should be credited to the corresponding prepaid asset account. Then, at the end of each period, or when the expense is incurred, an adjusting entry should be made to reduce the prepaid asset account and recognize (credit) the appropriate revenue expense, which will then appear on the income statement.
Why are upfront expenses not initially on the income statement?
Prepaid expenses are not included in the income statement under generally accepted accounting principles (GAAP). In particular, the GAAP matching principle requires accrual accounting. Accrual accounting requires that regardless of when cash or currency changes hands, revenue and expenses are reported in the same period as they occur. That is, expenses should be accounted for as they occur. Therefore, prepaid expenses are not recognized in the income statement when they are paid because they have not yet been incurred.