Two ways of accounting for prepaid expenses

September 14, 2010

Two methods to account for prepaid expenses: balance sheet approach and income statement approach.

1. Nature of prepaid expenses

Prepaid expenses are expenses paid for in advance and recorded as assets before they are used or consumed. Prepaid expenses are shown in the assets section on the balance sheet.

Examples of prepaid expenses can be insurance premiums or rent. When a company pays insurance premiums in advance, the insurance coverage relates to a future period. The same is true for rent: when a company pays rent in advance, the rent is related to the occupancy of premises (i.e., building) in the future. Therefore, insurance and rent expenses relate to future periods, and thus, they are called prepaid expenses.

When the insurance coverage starts or the rent period begins, the company will start expensing the prepaid amount. The expensing is usually done over the term of the insurance coverage or rent on a straight-line basis. However, note that other methods of amortization (different from straight-line) are also applied.

Prepaid expenses usually represent a short-term asset because they will be consumed (amortized) over a year or less after the balance sheet day. Such assets are presented in the current assets section on the balance sheet. However, sometimes prepaid expenses might be amortized over a period longer than a year after the balance sheet date. In such cases, the portion which is to be amortized to expenses after one year after the balance sheet date is considered non-current and presented in the non-current assets section on the balance sheet.

For example, on March 15, 20X0 a company pays $12,000 for insurance coverage which will run from April 1, 20X0 to March 31, 20X1 (one year). The company has its accounting year end on December 31. On December 31, 20X0 the unused prepaid insurance expense of $3,000 (3 months: January 1, 20X1 March 31, 20X1) will be considered short-term and shown in the current section of the balance sheet because the balance will be liquidated (amortized to expense) within a year after December 31, 20X0.

Let's use the same scenario, but this time the company pays $24,000 for the insurance coverage which will run from April 1, 20X0 to March 31, 20X2 (two years). This time on December 31, 20X0 the unused prepaid insurance expense of $15,000 (15 months: January 1, 20X1 March 31, 20X2) will be split into two parts. The short-term portion will be for the 12 months after December 31, 20X0 and equal $12,000 (because this balance will be amortized within a year after the balance sheet date). The long-term portion will be for the 3 months for the period after December 31, 20X1 and equal $3,000 (because this balance will be amortized after a year after the current balance sheet date). The two amounts $12,000 and $3,000 will be shown in the current and non-current assets on the balance sheet, respectively.

2. Two methods of accounting for prepaid expenses

We would like to describe two methods of accounting for prepaid expenses. We will call them the balance sheet approach and the income statement approach, and you will see below why we call them so.

There is no difference in the final result whether a company uses the balance sheet approach or the income statement approach. It is more a matter of preference or convenience or accounting system capabilities.

Assume Company XValveProducts buys business insurance. The insurance coverage runs from May 1 to April 30. Insurance premium payments are usually made by May 1 (in advance for the upcoming covered year).

For the current year Company XValveProducts paid the insurance premium in the amount of $24,000 on April 15, 20X0. Hence, monthly expense equals $2,000 (i.e., $24,000 ÷ 12 months).

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