Diving Deep on Prepaid Expenses
We’ve talked about it many times before, in our blogs on Understanding Accrued Expenses and Do You Need a Bookkeeper or an Accountant?, to name a few instances, and we’re going to talk about it again before we get to our main discussion of prepaid expenses. And that is the difference between cash and accrual accounting. This is simply too important a concept not to. Are you ready?
In cash accounting when you receive cash, income is immediately recorded on your books. And when cash is spent, an expense is immediately recorded on your books. However, this simple “cash in, cash out” record-keeping style rarely paints an accurate picture of the health and profitability of your business because it doesn’t show what is truly being earned or spent each month.
Now say it with me, enter… accrual accounting. Accrual accounting aims to make up for the shortfalls of cash accounting’s method by creating a more true representation of reality by centering around the idea of service and / or value transfer (instead of cash transfer). Therefore in accrual accounting income is recorded when it is earned (not when cash or a check is received) and expenses are recorded when there has been a transfer of service / value (not when the cash is spent or a bill is paid).
So what is the point of including the complexity of accrual accounting when there is technically an easier route via cash basis accounting? Accrual accounting makes absolutely sure that your financial data is creating a true and accurate image of your company and that they provide deeper insight into your financials by allowing you to see trends in your numbers.
What Are Prepaid Expenses?
I would love to keep talking about cash vs. accrual accounting, but we’re here today to discuss prepaid expenses! Prepaid expenses refer to a cost that has occurred but where the service has not yet been consumed so it is recorded on your balance sheet for one or more future accounting periods as an asset until it can be moved from the balance sheet to the income statement as an expense (because it has finally been consumed).
In other words, a prepaid expense is an asset that represents the advance payment of an expense that has not yet been incurred.
We Need Examples
I don’t know about you, but I learn best by walking through an example. Below we’ve outlined two prepaid expense examples to cement our understanding. Shall we begin?
Supporting Local Business
Let’s say that Simple Startup loves to support local businesses (we really do!) by subscribing to a local monthly snack box. Let’s also say in January we purchased an annual subscription for $600 which breaks down to $50 per month. When we purchased this subscription in January we would represent this operational expense on our books as an asset of $600.
As each month goes by and each box is received by Simple Startup, $50 would be subtracted from the asset entry on the balance sheet and moved to an expense on the income statement.
Since there’s a lot at stake here (#accuratedata), let’s look at one more example to make sure we all truly understand prepaid expenses.
Like all businesses, Simple Startup has business insurance. For this example, let’s say our business insurance costs $12,000 for the entire year and we pay for it twice a year in January and July. In January when we prepay $6,000 for the first six months of business insurance, we record that prepayment as an asset on our balance sheet to represent that although we have paid for the service it has not yet occurred.
Then each month, once the service has been consumed, we move $1,000 (the cost of 1 month of insurance) to our income statement as an expense. This will occur until June when the full first payment of $6,000 has been consumed and we pay in advance for business insurance for the second half of the year and we perform this same exercise all over again, so our expenses appear appropriately in our financial records.
Other common examples of prepaid expenses may include startup costs, advertising expenses, legal or consultant retainers, and annual office rent.
How Can Tracking Prepaid Expenses Improve Your Business?
If you consider the purpose of an income statement, what it is trying to accomplish is to showcase what a business has truly earned in a period of time, and what its expenses were. This will provide an overarching picture of profitability in that given period. The reason an income statement can provide this clarity in profitability is that it is built on the foundation of accrual basis accounting.
If you were to try to understand your profitability using cash basis accounting the vision becomes muddied by the cash being recorded the month it comes in / goes out and not over the period it was earned or a service was received. This would make it all but impossible to make informed decisions based on your numbers because they would ultimately be inaccurate.
Do I Have to Do This On My Own?
Even with two examples, the concept of keeping track of prepaid expenses can be complex, which is why we think a sneak peek at what a professional supporting schedule looks like might help you do this exercise on your own. Click here to access a PDF copy of the supporting schedule that we use to record prepaid expenses so you can have an even more clear vision of how to become an accounting whiz in your own business.
If you’re thinking that you already have too much on your plate, we’d love to help you manage the accounting functions within your company. All you have to do is schedule a discovery call and we’ll help you customize an outsourced accounting program that is just right for your business.