Prepaid Expense
Prepaid expense (also called prepayment) is an asset which arises when a business pays an expense in advance.
In accordance with the matching principle, the advance payment is not recorded as an expense at the time of payment because it relates to future expenses. It is recorded as an asset initially and written-off as expense through an adjusting entry when the expense is actually incurred.
Prepaid expenses are reported on a balance sheet as a current asset when they relate to expenses that are expected to be incurred within the next 12 months and non-current asset otherwise.
Common prepaid expenses include prepaid rent, prepaid utilities expense, prepaid lease rentals, etc.
Journal entries
When a payment is made for a future expense, the following journal entry is made:
| Prepaid expense | ABC | |
| Bank | ABC |
As the related expense is incurred, prepaid expense is written off proportionately as follows:
| Expense | DEF | |
| Prepaid expense | DEF |
Example
PMTA, Inc. is a leading financial services IT company which recently entered into a 10-year contract for a 2-storey space in a leading IT business hub and paid 3 years rent in advance on 1 July 2015 which amounted to US$ 9,000,000.
The company’s financial year ends on 31 December. Journalize the transactions in the books of PMTA, Inc.
The payment of 3 years rent in advance can’t be recorded as expense because it spans more than 3 accounting periods and the generally accepted accounting principles don’t allow such an accounting treatment. Instead, it is recorded as an asset initially:
| Prepaid rent | $9,000,000 | |
| Bank | $9,000,000 |
At the end of the financial year, an adjusting entry is made to recognize rent expense for the period for which the building has been used. The expense is recognized on proportionate basis i.e. monthly rent is calculated by dividing the total rent for 3 years (which is $9,000,000) by total number of months in the period (i.e. 36), and multiplying it by the total number of months for which the company has used the building (which is 6).
| Rent expense ($9,000,000/36*6) | $1,500,000 | |
| Prepaid rent | $1,500,000 |
Prepaid rent is presented on the balance sheet as at 31 December 2015 as follows:
- An amount of $3,000,000 appear as ‘prepaid expenses’ in the current assets section, representing the prepayment that relates to next twelve months.
- An amount of $4,500,000 [= 9,000,000 – 1,500,000 – 3,000,000] appear under non-current assets section, representing the prepaid rent that is expected to be consumed in the period after next 12 months.
by Obaidullah Jan, ACA, CFA and last modified on