What are Prepaid Expenses?

Do you know what a prepaid expense is and how/if it impacts the P&L? Why do companies prepay expenses, and what are some examples? Non-finance managers often struggle to account for prepaid expenses and understand their impact on financial statements. Let's dive in!

A prepaid expense is actually NOT an expense and has NO IMPACT on the P&L whatsoever. Confused? I don't blame you. I hear you saying: "Surely a prepaid expense is - an EXPENSE ?" The answer is - a prepaid expense is NOT an EXPENSE. In the clip below, let's get a deeper understand of what an expense is to understand why a prepaid expense is not an expense.

As I explained above in order for something to be classified as an expense, we have to have USED that something.

Prepaid expenses are things we prepay NOW but only USE in the FUTURE.

IE. Prepaid advertising - we pay for the advertising now (perhaps to take advantage of a discount) but will only use the advertising next year.

Prepaid rent - we pay upfront for rent for the year to get a better rate.

Prepaid insurance - We prepay for the coming year to take advantage of the better rate offered.

At the time we make the payment, we have NOT USED anything. We have not enjoyed or made use of the service we have paid for. We have not yet made use of the advertising, we have not yet made use of the office space we are renting or have not yet made use of the insurance cover.

Because there has not yet been USAGE, there can be no expense recorded at the time of the prepayment.

So, what is a prepaid expense and how do we account for it?

A prepaid expense is actually - AN ASSET. Why ? Because we OWN and CONTROL the RIGHT to that particular service in the future. Assets are things that have value which we own and control and assets appear on our balance sheet, not on our P&L.

To help you understand more, I recorded this clip where I demonstrate on my gamified financial playground, how we treat prepaid expenses:

And there you have it! A prepaid expense is an ASSET and has no impact on the P&L at the time of the prepayment.

Would love to hear your comments and questions.

Have a great day.

Best,

Mark

www.accountingmadeeasy.co

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