Last editedSep 20222 min read
For business owners of all kinds, it’s important to develop a good understanding of accounting practices so that you get a good picture of your company’s financial health. There are several different metrics that you can use to do this, as well as some essential concepts to learn, such as how to add prepaid expenses on balance sheets.
A prepaid expense is a kind of business asset that you will need to record on your balance sheet. This means that they represent a resource with economic value that is expected to bring future benefits. But how do you classify prepaid expenses on balance sheets, exactly? Keep reading to find out more about prepaid expenses and how your business should record these.
What is a prepaid expense?
Before answering the question “where do prepaid expenses appear on balance sheets?”, you first need to understand what is meant by a prepaid expense. In a nutshell, these are assets that appear on your balance sheet as a result of purchasing goods or services and paying for these in advance. This means you have paid, but have not yet received the goods or services.
But what is an asset, exactly? It’s a broad term that can be used to refer to anything with financial value that is controlled by a company, country or individual. Your business may have any number of diverse assets, ranging from real estate to office equipment to cash. Naturally, it’s important to keep track of these assets, which is where the balance sheet comes in.
Some of the most common prepaid expenses include:
insurance policies, which are generally paid for the upcoming year; rent, which will usually be paid for months in advance; and interest and taxes, which may be made ahead of the due date.
What is a balance sheet used for?
To get a better answer to the question “what are prepaid expenses on a balance sheet?” it’s also a good idea to know exactly what a balance sheet is and what it is used for. A balance sheet is a financial picture of your company at a given time, showing what you own, what you owe and how much is invested in the business.
You might also hear the balance sheet referred to as a ‘statement of financial position’. It’s one of the core financial statements for any business, along with your cash flow statement, debtor reports and the profit and loss statement.
A balance sheet is made up of three main parts:
Assets are all the things that are owned by the business and that hold financial value, such as cash, accounts receivable, and of course, prepaid expenses.
Liabilities, which may also be known as debt. These are things that are owed to other individuals or companies, such as unpaid bills or outstanding loans.
Equity, which represents the initial investments in the company, along with any additional income or losses that you’ve made over time.
Where do prepaid expenses appear on balance sheets?
So, how do you classify prepaid expenses on balance sheets, exactly? When you pay for an expense, it will be recognized as a prepaid asset on the balance sheet. You’ll also need to record an entry that reduces your cash or payments account by an equivalent amount. Unless the expense will not be incurred until after 12 months, you should record the prepaid expense as a current asset.
According to accounting principles, prepaid expenses should not be included in your income statement. This follows the rules of accrual account, which states that you must report revenue and expenses at the same time as they are incurred, regardless of when you actually make or receive payments for these.
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