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Prepaid Expenses

Introduction:

How to handle prepaid expenses can be confusing.  Once you see the pattern, they are easy.  Prepaid expenses all behave the same.  Some examples of prepaid expenses include prepaid insurance, prepaid rent, prepayments for legal services to be received, and prepayments for office supplies (buying them before you use them).  The list can go on.  Prepaid expenses are basically anything you must pay in advance before receiving any benefit.

Theory vs. Reality

All accounting textbooks teach us accounting theory.  Theory is a good thing to know in accounting.  Due to the creativity of people, new ways of structuring transactions between businesses, consumers and other parties are being developed and these transactions are increasing in complexity.  Accounting theory will guide a business person on how to record these new transactions properly.  This is important because all of these recorded transactions show up on the balance sheet and income statement and are used to make business decisions.

With all that said, business people sometimes choose to ignore accounting theory when recording some prepaid expenses.  The reason for this is some prepaid expenses like prepaid rent happen continuously (every month) and it is just easier and more time efficient to record the transaction in a simplified manner.   In addition, in the case of prepaid rent paid each month, the method used to record the prepaid rent will not make much of a difference on the balance sheet and income statement.  To take it a step further, the difference in the accounting information is so insignificant, that it does not affect any business decisions.          

Click on either of the two links to see how prepaid expenses are handled:

The Accounting Textbook Theory Method       The Real World Method