What are Prepaid Expenses in Financial Accounting?
What are Prepaid Expenses in Financial Accounting?

As the term prepaid itself implies that it is the cost or amount of money that has been paid in advance. It can be considered as future expenses mainly because the sum of money paid is neither used nor it is expired. Here we are going to see all about prepaid expenses accounting.

Prepaid expenses are not expired hence the company mentions the expenses on its balance sheet. The balance sheet aims to cover all the unexpired costs and expenses of a particular company or a business.

The assets stored by the companies in the form of prepaid are usually done in order to make sure that they can get future benefits out of it. Prepaid expenses are not for long-term purposes as they expire after a certain period of time and after businesses have consumed the amount that is saved as an asset.

 

Ways in Which the Prepaid Expense Can be Accounted

The prepaid expense can be termed, as either as an expense or as an asset depending on the way different businesses want it to be stored. The way the prepaid money would be treated is different in both the cases.

If prepaid money is stored as an expense that after a particular accounting time ends the expense amount that has been decided for that particular period should remain in that account. Rest of the amount or the future expense can be either debited to the prepaid asset account of that company or it can be transferred to the other expense account that is dealing with all the future expenses.

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However, if the prepaid money is stored as an asset then the expired portion of the asset should be removed so that the portion that is still valid remains in the account and can be used by companies whenever they are in need.

 

Prepaid Expenses can be Beneficial

Businesses use prepaid expenses mainly to earn benefit out of the money that is paid in advance. It tends to protect people from anything unfortunate that might happen over the course of time. Insurance is a form of prepaid expense, as people tend to buy protection of valuable belongings like a car, house etc., in case anything bad might happen.

A certain amount of money would be stored in the insurance account to complete your payment. Every month a certain amount of money would be deducted till the money fully reaches the amount of zero.

Businesses who have to make a lot of investments in order to expand their business often carry prepaid expenses whenever they can so that the number of prepaid expenses continues to increase until the amount reaches a point that can be used by the companies to their advantage on the balance sheet.

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Risks Involved in Prepaid Expenses

However, everything has two sides to it. It can be negative or positive or it can be both. Same is the case with prepaid expenses as companies that are making advance payments in the form of prepaid expenses and if they tend to increase it every month then it would have an impact on the overall functioning of the company as the cash flow along with working capital would be decreased.

It might affect the amount of income generated with the help of working capital. Whereas a decrease in the number of prepaid expenses would result in an increase in the cash flow. It is a two-way system hence people have to be careful in terms of deciding the amount that they are willing to decide as a prepaid expense.

Businesses and companies should examine their cash flow and other immediate expenses before they decide to increase their prepaid expense every month or every year.