Who Benefits from Prepaid Expenses?

Businesses and individuals alike incur expenses. To generate revenue, entities must pay for expenses such as supplies, wages, facilities, utilities, rent, equipment, and vehicles. For corporations, expenses are part of the cost of doing business, while individuals incur expenses as part of their cost of living.

While most expenses are paid when a good or service is bought or delivered, others are paid in advance. The latter are called prepaid expenses. Both individuals and businesses can benefit from prepaid expenses, although for different reasons.

Key Takeaways

• Prepaid expenses are expenses that are bought or paid for in advance, and may include things like insurance, rent, utilities, and subscriptions.
• Individuals benefit from prepaid expenses by ensuring they don’t miss payments for important services like health insurance.
• Companies may prepay some of their future expenses to increase cash flow, secure discounts, or qualify for business deductions.

What Are Prepaid Expenses?

Prepaid expenses are expenses that are bought or paid for in advance and may include insurance, rent, utilities, and subscriptions. In general accounting, these are supplies or services that the company has acquired but has not used during a specified accounting period.

Examples of common prepaid expenses include:

• Rent
• Taxes
• Insurance
• Utility bills
• Subscriptions
• Interest
• Legal retainers
• Bulk supply orders

Prepaid expenses are different from a company’s inventory, as prepaid expenses are consumed over time while inventory is sold to generate revenue. Unused prepaid supplies or services are recorded as assets on a company’s balance sheet as they have future, unrealized value. Once that value has been realized, the asset is effectively consumed or used, and the service or supply is recorded as an expense.

Important

Corporations consider the accounting implications of using a prepaid expense before deciding to use them in order to take advantage of the tax deductions.

Reporting Prepaid Expenses

Businesses have different methods of reporting prepaid expenses on their balance sheets.

Companies generally carry prepaid expenses on their balance sheets and designate them as current assets until they are fully consumed. After this initial recording, a periodic entry is made—often monthly or quarterly—recognizing the use of the expense during each period covered by the prepayment. If the product or service in question is used over months or years, businesses may charge their expense accounts several times during that period. For each period that money is spent, that amount is moved from the company’s balance sheet to its income statement, reflecting that the service or supply has been used.

Who Do Prepaid Expenses Benefit?

Prepaid expenses benefit both individuals and businesses. Let’s explore how each stands to gain from leveraging prepaid expenses for personal or business use.

Benefits for Individuals

Prepaid expenses provide many benefits for individuals. On the practical side, it is best to fully pay for a service or product ahead of time, especially if it is an expense you cannot avoid. For example, if you cannot live without health insurance, you will want to pay for it in advance just to make sure that you will not miss your payment.

Prepaying expenses can also lead to significant savings. One good example is a prepaid college plan or 529 plan. A prepaid tuition plan allows you to buy units of tuition in advance. You can pay for several units or one or more semesters of tuition in a college or university of your choice at the present rate. In other words, you pay today’s tuition fee rate regardless of when your child attends the university. Considering that tuition fees increase at an alarming rate—inflation-adjusted—if you open a 529 plan ten years before your child goes to college, your savings can be quite significant. It is the same with other prepaid expenses, such as prepaid maintenance costs for cars. The price is locked in, so you avoid the rising cost of the product or service, similar to a 529 plan.

Despite these benefits, there are other things to consider before paying in advance, such as whether the company will be able to provide the service or product in the future. If the corporation or entity goes out of business, individuals may be left having prepaid for a benefit that they can no longer use.

Benefits for Businesses

Prepaid expenses offer businesses the same savings benefits as those earned by individuals. In addition to savings benefits, businesses can also benefit from tax deductions. Typically, expenses are only deductible in the year in which they apply. However, under the 12-month rule, the IRS allows businesses to deduct expenses during either the 12 months after the right or benefit begins or the end of the tax year after the tax year in which prepayment is made, whichever is earlier. Businesses in need of a tax deduction may leverage prepaid expenses to take advantage of a deduction within a year other than when the expense was originally incurred.

Another reason businesses might use prepaid expenses is to improve budgeting, reporting, and cash flow management. Prepaying for an expense ensures that a business avoids risks of future unavailability and creates room in the budget for future expenses. Accurate reporting gives businesses vision over cash flows, allowing them to plan for future outflows and reduce cash shocks.

Are Prepaid Expenses Assets?

Yes, businesses initially record prepaid expenses as assets because they have a future value that has not yet been realized. As expenses are realized, they move from a company’s balance sheet to its income sheet and cease to be assets. That said, this only really applies to expenses prepaid months or years ahead of time and excludes expenses that are realized within a few days or weeks.

What is Amortization of Prepaid Expenses?

Amortization is the accounting process used to calculate how expenses are spread out over different periods as an asset’s value is realized. As prepaid expenses are used, amortization reduces the asset’s value on the balance sheet. Prepaid expenses are typically amortized using the straight-line method, which spreads out the expense evenly over the benefit period.

How Do Prepaid Expenses Affect Net Income?

When businesses or individuals prepay for expenses, they reduce their current net income, as cash is being spent today rather than in the future. The benefits of future savings, improved management, and possible tax deductions may outweigh this current reduction in income.

The Bottom Line

Prepaid expenses are bought or paid for in advance. This practice can provide numerous benefits, including savings, tax deductions, and improved financial reporting or cash flow management. Businesses may prepay a vendor to build position relations, while individuals enjoy the security earned by paying for important services in advance, therefore ensuring they don’t miss a payment on accident.