Your guide to mastering prepaid expenses

Prepaid expenses are a fundamental accounting treatment that every accounting team must manage. While often straightforward, their complexity and how they fit into your accounting process depends on multiple factors. To effectively track and record these expenses, it's crucial to understand their current impact, anticipate future changes, and adapt your processes as your business evolves.

Get started tracking your prepaids better by using Numeric’s prepaid expense workpaper template here.

Lucy’s Lemonade Stand

Lucy's Lemonade Stand is the talk of the neighborhood. Her fresh, hand-squeezed lemonade has won the hearts of both young and old. But Lucy is ambitious and is always looking for ways to innovate. One day, while browsing online for ways to upgrade her stand, she stumbles upon a software that catches her eye: "CitrusOne."

CitrusOne is a venture-backed vertical SaaS product tailored specifically for lemonade stands. The company promises to turn any ordinary lemonade stand into a thriving, efficient, and fun business operation by helping her track inventory, forecast revenue based on weather patterns, and launch a loyalty program.

Intrigued by the idea, Lucy decides to invest in an annual subscription.

After negotiating hard on the last day of the sales quarter, Lucy pays $12,000 upfront for this annual subscription and 2% of each transaction processed – because after all, CitrusOne is also a fintech company. Since she is paying for the software in advance and will receive the benefits over a period of twelve months, this is considered a prepaid expense.

In accounting terms, Lucy's lemonade stand would handle this as follows:

When Purchasing the Subscription (Prepayment):

• Debit (increase) Prepaid Expenses: $12,000
• Credit (decrease) Cash: $12,000

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At the End of Each Month: Lucy's lemonade stand will amortize (recognize) the cost of the service plan as an expense over six months. Since the plan costs $120 for twelve months, $10 will be expensed each month.

• Debit (increase) Expense: $1,000
• Credit (decrease) Prepaid Expenses: $1,000

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By the end of one year subscription, the entire $12,000 will be expensed, and the Prepaid Expenses account will be reduced to $0.

Now that you’ve seen how the enterprising Lucy handles her prepaid expenses, it’s time to take a deeper look into what prepaid expenses are and how they work — and look at ways to optimize your prepaid expense processes.

What is a prepaid expense?

Prepaid expenses are expenses for goods or services paid in advance. They’re first recorded on your company’s balance sheet as an asset. The goods or services are then recognized as expenses as they are consumed or utilized over time, aligning with the matching principle of accounting. This process ensures that expenses are recorded in the period in which they are incurred, reflecting a more accurate picture of an organization's financial position and performance.

Why do prepaid expenses matter? 

Prepaid expenses are unavoidable. Many types of expenses must be purchased for a year, or multiple years, in advance. Favorable terms are often provided in return for the commitment to longer-term contract and the short-term cash flow impact of the higher initial outlay. 

In addition to reducing the capital available, without the proper accounting processes and software, companies can struggle to track and adjust the value of prepaid expenses. Without accurate adjustments, prepaid expenses can create misrepresentation on a company’s financial statements, potentially leading to regulatory non-compliance and distorted financial analysis. Such inaccuracies can undermine stakeholders' confidence, hamper decision-making processes, and even expose the organization to legal or financial risks. 

Therefore, precise tracking and adjustment of prepaid expenses are critical to maintaining the integrity and accuracy of a company's financial reporting, and it is important that teams create a robust process to track their prepaid expenses, calculate amortization amounts, and ensure that the prepaids subledger reconciles to the general ledger. 

An excellent place to start is by downloading Numeric’s prepaid expense workpaper template here.

How to handle prepaid expenses

Logging your prepaid expenses correctly into your balance sheet is crucial for tracking costs and maintaining accurate financial records.

Recording prepaid expenses

You won’t initially record prepaid expenses on the income statement. Per GAAP (Generally Accepted Accounting Principles) and IFRS (International Financial Reporting Standards), you cannot record prepaid expenses on the income statement before they incur.

Prepaid expenses are typically considered current assets since they’re expected to be used within a year for standard business operations. However, a multi-year contract will add some complexity in having both current and non-current asset components. 

Initially, prepaid expenses are recorded as an asset on the balance sheet in a prepaid expense account. The accounts should be titled in a way that identifies the prepaid expense appropriately and distinguishes it from other assets.You’ll enter the total amount paid for the expense. 

Prepaid expense amortization

As prepaid expenses are used (or realized), you’ll reduce the asset account by that amount and recognize an expense. This process of expensing the amount utilized in the current period is called prepaid expense amortization.With each amortization entry, the amount reduces gradually to zero, and the expense transfers to the profit and loss statement for the period when the business uses up the accrual.  

Example Journal Entry

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1. Initial Prepaid Expense Recording: When the company pays for the software subscription in advance, the journal entry would debit (increase) a prepaid software asset account and credit (decrease) the cash or bank account.

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‍Monthly Amortization of the Prepaid Expense: Assuming this is for a 12-month subscription, each month, as the company uses the software, they would expense 1/12th of the total prepaid amount and reduce the prepaid asset accordingly.

This process would continue monthly, reducing the prepaid software asset by $10,000 each time and recognizing it as an expense, until the full $120,000 has been expensed over the year.

Common prepaid expenses

Almost all businesses have prepaid expenses because of how some goods and services are sold. Common prepaid expenses include:

1. Software: Today’s software is often subscription-based. When you pay for a year or more in advance, that’s a prepaid expense. This might include your web hosting, operational software, or marketing platforms.
2. Insurance: Insurance premiums are a typical prepaid expense. Policies for insurance coverage are generally for multiple months and paid in advance. 
3. Rent: Companies may choose to make advance payments for their rent expense. This assures that they won’t miss payments or allow them to secure a space. 
4. Leased equipment: Machinery or office equipment are considered prepaid expenses when you pay the lease in advance. 
5. Legal retainers: It’s not unusual for attorneys to have clients “reserve” legal services from a lawyer with a retainer. By paying fees in advance, you’re ensuring your attorney is available to work when needed.
6. Travel expenses: If a company secures travel arrangements for employees with a deposit, it’s a prepaid expense. This includes flights, hotel expenses, and participant fees for an event.
7. Deposits: When a deposit is used to offset a future expense, and the funds are removed from your account (not frozen), it is categorized as a prepaid expense. A good example is a deposit for an event venue that will be used to help cover the cost of the venue.

How are prepaid expenses handled at nonprofits?

Prepaid expenses are handled the same for nonprofits. The primary difference will be the types of financial reports or statements they may be included on. For example, a Statement of Financial Position, which is a nonprofit balance sheet. 

When do prepaid expenses get complicated?

Prepaid expenses pose challenges, especially as you grow. Some common challenges companies run into are:

• Transaction volume: As a business expands, prepaid expense transactions often increase. This rise can make tracking, amortizing, and reconciling prepaid expenses time-consuming and prone to error.
• Multiple contracts: With more vendors and contracts, the terms and amortization schedules can vary widely, requiring individual attention and custom calculations.
• Multi-year contracts: Prepaid contracts for over a year will have current and non-current components. The non-current assets are capitalized rather than expensed, and future periods cannot be claimed as a deduction in the current year. With multi-year contracts, tracking and tax deductions are more open to inaccuracies.
• Non-standard periods: Some prepaid expenses may not have a simple monthly amortization. They may require daily, quarterly, or other non-standard periods, leading to more complex calculations and hire variation across the population. 
• Varying terms and conditions: Different agreements may have unique terms, discounts, renewals, or penalties, further complicating the amortization process. 
• Businesses operating internationally: Global operations may deal with prepaid expenses in various currencies, introducing complexities in conversion, fluctuating exchange rates, and compliance with international accounting standards.

Limits of existing systems

Not all ways of managing prepaid expenses are created equal. On one hand, spreadsheets, despite their flexibility, tend to be manually intensive and lack audit trails, leaving them vulnerable to errors and inconsistencies. Their open-ended nature can lead to deviations in practice that are difficult to control, raising concerns about reliability and compliance.

On the other hand, Enterprise Resource Planning (ERP) systems, known for their automation capabilities, often fall short in their adaptability. While ERPs can handle standard amortizations and provide a degree of reporting, they frequently struggle with more complex scenarios, offering only support for basic examples. This lack of flexibility can inhibit a company's ability to respond to unique contractual arrangements or evolving business needs. 

The good news is that accounting advances and optimized processes can minimize any challenges surrounding prepaid expenses.

Tips to improve your prepaid expense process (and how Numeric can help)

Modernizing your accounting improves your prepaid expense process. Assess where you’re at and identify what would streamline your operations. From here, you can standardize workpapers and begin to automate workflows.

1. Completeness: The first priority is ensuring that all necessary transactions are correctly coded in the prepaid subledger. By utilizing Numeric, teams can establish real-time monitoring and alerts. This automation will automatically trigger notifications about transactions requiring review, streamlining the oversight process.
2. Accuracy: Following the completeness check, teams must scrutinize the prepaid subledger to guarantee data accuracy and proper recording of all items. Numeric serves as a valuable tool in this phase, allowing teams to review all of their month-end accounting work in one consolidated location, thus enhancing efficiency.
3. Adjustment: Next, the necessary journal entry or entries are posted to the general ledger. Numeric offers the ability to track these adjustments automatically, providing a seamless connection between the subledger and the general ledger.
4. Reconciliation: Once adjustments have been recorded, it's vital to ensure that the workpaper aligns with the general ledger. Numeric facilitates this process by automatically pulling data from both workpapers (such as this best-practice template) and the general ledger. This integration ensures that the ending balance is appropriately substantiated, reinforcing accuracy and compliance.

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By leveraging a tool like Numeric, businesses can transform the often complex and time-consuming tasks associated with prepaid expenses into a streamlined and automated process. The result is a more accurate, efficient, and auditable management of this critical financial element.

Numeric’s template workpaper for prepaid expenses

Download our best-practice prepaid expense workpaper here. A well-structured Excel template can be a simple yet effective solution for managing prepaid expenses. It's designed to reduce errors and save time by providing a standardized structure with built-in formulas.

To get started, simply download the template here, and follow the included instructions. This easy-to-implement tool puts better control and clarity at your fingertips.

In conclusion

Prepaid expenses are a vital aspect of accounting that, though seemingly straightforward, can become complex and demanding, especially as a business grows. From the basic handling of a lemonade stand to the intricate management of multinational corporations, the precise tracking, amortizing, and reconciling of prepaid expenses are essential to accurate financial reporting and regulatory compliance. 

Utilizing modern tools like Numeric and adhering to best practices, teams can significantly enhance efficiency and accuracy in managing this critical financial component. 

By taking control of prepaid expenses through understanding, careful planning, and leveraging technology, businesses can ensure that they are in the best position to make informed decisions, remain compliant, and support growth. Thus, mastering prepaid expenses is not just an accounting necessity; it's a strategic advantage.