For small business owners or new entrepreneurs, prepaid expenses are something that they may not have encountered before due to how they straddle the line between expenses and assets.
When you purchase goods or services in advance, the capital expended to do so still leaves the business as a normal expense would. However, because you don’t receive them right away, that expense can’t be recognized at the moment and is still technically a part of the business. That makes it an asset in terms of bookkeeping.
Unlike regular expenses, prepaid expenses are typically reserved for only certain kinds of entries due to their nature. Rent and Insurance are more commonplace examples of these. However, even these can be regular expenses depending on the circumstances.
Rent is the payment made to a property owner and is a typical general expense for businesses that have a physical presence. If you pay the rent in advance of the necessary due date, such as if you are paying for the next month or quarter, then it would classify as a prepaid expense. However, if you are paying as you typically go then it would be a regular expense.
Insurance is a payment made for a guarantee of compensation in the event certain circumstances come to pass, such as a fire, injury, or a lawsuit. Since most insurance plans require a premium to be paid in advance for a coverage period, that naturally falls under a prepaid expense. However, if you enter into some kind of pay-per-month plan, then it would be an expense instead.
These two are typically prepaid expenses because a business often needs to have their living arrangements or insurance policies extend over a longer period. Paying in advance for these services means that the owner or provider now has an obligation towards the business owner to fulfill their end of the bargain for the terms that were agreed upon. Once the period listed in the terms have expired, the prepaid expenses will be emptied as a regular expense.
There are more complications with it, such as how adjusting entries are needed to account for prepaid expenses. However, that simple understanding should be enough to help you understand the key differences between them. We will cover how to handle the adjusting entries at a later date, so please subscribe to our blog and feel free to Contact Us if you want our help leaving your books in the black.
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