Prepaid expenses are payments for goods or services rendered after the date of payment. Typically, such services are consumed in the near future in the normal course of business, but you might also come across prepaid expenses that will stay on the Balance sheet for several years. Examples include prepaid rent, insurance, taxes, and subscriptions.
The concept of prepaid expenses can be explained as follows: you pay for something and then you expense it for several months or even years. However, do not let the word expenses confuse you. Since the company that made the payment in advance has not yet consumed the goods or services paid for, it would be wrong to place these payments in the accounting records as expenses. Instead, you will see prepaid expenses listed as assets on the Balance sheet of the organization.
So, when it comes to prepaid rent, we can say that for the company that paid the rent it is an asset. In other words, it still has some period of time during which it can rent the space without needing to pay anything because it already did so in previous periods. From the landlord’s perspective, the prepaid rent will be accounted for as unearned revenue because they still have to provide the property for rent for a specific period of time before the rent payment will be truly earned.
On April 25th, your company wrote a check to pay for the rent of the office space you are using. The amount on the check was equal to $6,400 and is supposed to cover the rent for the period from May 1st till August 31st. Since you paid the money for rent, it might be very tempting to enter this amount in your accounting records as an expense. However, from the accounting point of view, this would be completely incorrect.
Imagine that after one month, the company says you will no longer be able to rent that office space. Whether willingly or through court, they will give you back your money for the time you have not used your prepaid rent. Since you have not consumed the rent you paid for right after you paid for it (or even a month later in our case), you will record this prepaid rent as an asset in your books. To do this, you will simply debit an account typically called Prepaid Rent. The amount you are going to debit will be the full payment amount of $6,400.
Besides making an entry in your Prepaid Rent account, you will need to make a balancing entry in another account. Since cash in your bank account went down when you wrote the check, you will credit the Cash account for $6,400 as well because that is how much you paid (exchanged) for the promise of rent of office space for your company for the next 4 months.
What is going to happen at the end of May? You have used up one month of the rent you have paid in advance. Accordingly, you will no longer be able to return the money you paid for it, so your assets are going down. To reflect this, you will credit the Prepaid Rent for the amount of one month’s rent or $6,400 of prepaid rent divided by 4 months, which gives us $1,600.
Now, the net amount of the prepaid rent is going to be $6,400 less $1,600 or $4,800. If you would prepare a Balance Sheet at the end of May, you would report $4,800 under Prepaid Rent. To ensure the accounting balance is maintained, we need to have a second account in our journal entry. Now that you actually used the office you rented and paid for that rent, you can finally record a business expense.
Usually, you would simply call the account Rent Expense. To continue with our example, you need to make a debit entry under this account to increase the amount of rent expense your business incurred as of today. That’s it! Next month, you will repeat the journal entry we made at the end of May and will continue doing so every month until you will exhaust the prepaid rent, which will be on August 31st.
As you can see, if you understand the concept of prepaid expenses, it can be applied to any expense in your business. The example we just reviewed should have helped you grasp this topic and apply the new knowledge to real-life cases of prepaid rent and other prepaid expenses.
Author: Charles Lutwidge