What are Prepaid Expenses?
You've paid for a year's worth of services from a vendor. Now where does it go on your books? The answer depends on if you're using cash or accrual basis accounting. Take a look at our prior blog entry on Cash versus Accrual if you need a refresher on these two types of basis for accounting and bookkeeping.
Cash basis is fairly easy. Whenever an expense is paid it is recognized. Therefore when cash changes hands the expense is recorded. If you've received a bill for a service, but have yet to pay that bill the expense is not recognized yet.
The tricky part of prepaid expenses comes with accrual accounting. With accrual accounting the expense is recorded when it is incurred. So let's break this down with an example. If I sign up for a service contract that covers 12 months of maintenance on April 1st I have promised to pay the provider for 12 months of services. I don't record anything until I either use the service or play for the service. As I use the service every month I record the expense for that month. Thus allocates the expense over the period of time I'm actually using it. I record this expense regardless of when I actually pay the vendor.
When I pay the vendor I take funds from my cash account (or increase my credit card balance). If I am paying for a service I've already used I reduce my accounts payable. But if I'm paying for services I will use in the future I increase an asset account called prepaid expenses. Prepaid expenses is an asset account because it is something of current or future value. As I use up the prepaid expense I decrease prepaid expenses and increase the expense account.
Each time you close the books, which is often done on a monthly basis, you should be adjusting the prepaid expenses account to reflect the expenses that have been "used up." Adjusting entries are completed by decreasing the prepaid expenses account and increasing the expense account.