What Is the Meaning of Prepaid Expenses?
Prepaid expenses are payments that a company makes to a vendor before a bill is due. A company may pay the water or power bill for several months before the water or power is turned on, or subscribe to a magazine for a year or more before the magazine is received. The company is paying for the service or product before receiving it, which creates an asset. The company records an expense when it receives these services, which eliminates the asset.
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Current and Long-Term
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Like other assets, prepaid expenses can include a current portion and a long-term portion. Magazine subscriptions are often available for a period of more than a year, so if the company buys a five-year magazine subscription, the cost for the first year is a current asset, and the cost for the next four years is a long-term asset when the company initially records the asset.
Recording Process
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The initial transaction does not affect any liability or owner's equity accounts. The company is trading a current asset, cash, for the current asset portion of the prepaid service and the long-term asset portion of the prepaid service if it exists. This means that the company will have to make additional adjusting entries later, reducing the prepaid expense asset and recording an expense.
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Year-End Considerations
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An organization's year-end financial reporting date affects what it considers a prepaid expense. An organization does not have to end the year on December 31 for reporting purposes, and can select another date such as June 30, according to Eastern Michigan University. If the company pays for services that it or its employees will receive after the year's end date, it records them as prepaid expenses, and makes the adjusting entries when the services are received the following year.
Conversion
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When a company has a prepaid expenses account, it periodically converts this account into an expense. If the service provider normally charges by the month, each month the company records the monthly cost of the service and reduces the value of the prepaid expense asset by this amount, according to Evergreen University. If an insurance policy, or another asset, requires a five-year subscription, the company must calculate the cost of service for the current year when creating the annual financial report.
Materiality
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Some institutions establish a minimum charge when recording a prepaid expense, such as a bill over $500. Organizations usually set a minimum threshold before deciding a purchase is a valuable asset that they should record, to reduce bookkeeping costs. A set of pencils or a notepad is not worth recording as an asset, and neither is a minor service, so the organization can record a minor purchase as an expense immediately without considering it a prepaid expense asset.
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References
- Photo Credit magazine image by Angelika Bentin from Fotolia.com
