Prepaid Expenses – Different Types of Incomes and Expenses
In the process of accounting, an accountant is required to classify each expense and income and put it into a specific method and entry. This is done so that there is a definite procedure in the accounting system of the organization and the benefits of recording these entries are enjoyed. The benefits of a good accounting system include the correct estimation of provisions, calculation of net profit, and also giving a good glimpse of presentation.
In this context, we are going to discuss Prepaid Expenses, Accrued Income, and Income Received in Advance from an organization’s point of view.
Overview of the Income and Expenses
Expenses that are to be charged in the future or simply the future expenses that are paid in advance are known as prepaid expenses. In this, the benefit of the expenses being paid in advance is recognized. They are initially treated like assets their value is expensed over time onto the income statement.
Now, what is accrued income and income received in advance? Accrued Income is the income that is earned but not yet received. ‘Income received in advance, as the name suggests, is the earned revenue which is to be earned in the future in an accounting period but is already received in the current accounting period.
Prepaid Expense
A company prepaying for an expense is to be recorded as a prepaid asset on the balance sheet and is termed as ‘prepaid expense’. The entry is being simultaneously added with another entry (the payment account) that reduces the cash balance of a business unit. Prepaid expense, being an ‘expense’ is still recorded in the asset side of the balance sheet as this is an advanced payment for the goods and services to be received in the future.
According to the Generally Accepted Accounting Principles (GAAP), expenses should be recorded in the same accounting period as the benefit generated from the related asset. For example, a company uses leased machinery for twelve months, the company benefits from it over a full-time period. Recording an advanced payment made for the lease as an expense in the first month would not adequately match expenses with revenues generated from its use. Therefore, it should be recorded as a prepaid expense and allocated out to expense over the full twelve months. Are prepaid expenses debit or credit? Prepaid expenses represent prepayment of an expense and hence it is debited and the cash account is credited. This records the prepayment as an asset on the company’s balance sheet, such as prepaid insurance and debits an expense account on the income statement, such as insurance expense.
Accrued Income
Accrued Income is the income that has been earned but not yet received. Accrued Income is to be recognized in the accounting period in which it arises but not in the subsequent period when it is received. For the journal entry, the income is to be credited to record the accrued income and a related receivable is to be debited to balance the transaction. The accounting entry will be as follows:
Accrued Income is an accounting concept that is a situation where a profit took place but was not yet received in the hands of the receiver. This event is recorded as receivable on the books. The concept of accrued income is used under the accrual basis of accounting. Here, the income can be earned even when the cash has yet not been received.
Income received in Advance
In some cases, the yet to be earned revenue belonging to a future accounting period is received in the current accounting period, then such income is considered as the ‘income received in advance’. This income is also called the Unearned Revenue, Unearned Income, Income Received but not Earned these names are because it is received before the related benefits that are being provided.
This revenue is not related to the current year’s accounting period, for example, the Rent which is received in advance, the Commission that is received in advance, all re income received in advance etc. This income is a personal account income and is shown on the liability side of a Balance Sheet.
Effect of These Expenses and Income on Financial Statement
Firstly, to record prepaid expenses, the current asset is reduced and the amount of reduction is reported as an expense on the statement. These are the costs that have been paid but are not yet expired and hence as the amount expires, the current asset is reduced and this is recorded as an expense in the income statement (a type of financial statement).
Next comes the accrued income. In the financial statement, the right to receive such income is displayed in the balance sheet (another type of financial statement) in the current asset section. This will be termed as accrued receivables or accrued income. The accountant debits an asset account for accrued revenue which is reversed when the exact amount of revenue is collected crediting accrued revenue. In the income statement, accrued income is recognized as revenue. Another associated accrued revenue account on the company’s balance sheet is debited by the same amount, usually under accounts receivable.
Revenue received in advance or Income received in advance is received before providing any benefits. This unearned income is shown on the liability side of the balance sheet.
Profit and Loss Statement
When a company prepays for an expense, it is recognized as a prepaid asset on the balance sheet and it reduces the company’s cash (or payment account) by the same amount. The prepaid expense is deducted from the particular expense while preparing a profit and loss statement.
In the case of accrued income, it is to be added with the related income in the profit and loss account and a new account of the accrued income will be shown on the asset side of the balance sheet.
The unearned income which is received before the benefits are provided is to be shown on the liability side of the balance sheet. While preparing the trading account, we need to deduct the amount of income received in advance from that particular income.
Outstanding Expense
Outstanding expense is the exact opposite of prepaid expenses, outstanding expense means an expense that is due i.e not yet paid. A company or a business unit takes the benefit but the related payment is not paid so far and this event leads to the occurrence of an outstanding expense to incur. The expense is due. Examples of such an event of expense outstanding are as follows
Rent past due but not yet received
Bills passed due but not yet received
Subscriptions passed due but not yet received
Outstanding expenses are to be recorded in the balance sheet on the liability side. This accounting takes place under the accrual basis of accounting. For example, wages earned by the employees are not recorded in the accounting records. This is to be entered through an accrual adjusting entry – debit wages expense, credit wages payable or credit accrued wages payable.
Journal Entry for Outstanding Expense
Outstanding expenses are recorded in the books of finance at the end of an accounting period to show the true numbers of a business.
The subject matter discussed on prepaid expenses, accrued income and income received in advance is one of the core studies for accounts. A good grasp on the matter is beneficial as the expenses and the incomes together form a business transaction and a financial event to take place accordingly.
FAQs on What Are Prepaid Expenses?
1. What are prepaid expenses in accounting?
Prepaid expenses are future expenses that have been paid for in the current accounting period but the benefits of which have not yet been received or consumed. These payments are initially recorded as a current asset on the balance sheet because they represent a future economic benefit to the company.
2. What are some common examples of prepaid expenses?
Common examples of expenses that are often paid in advance include:
- Prepaid Insurance: Paying an annual insurance premium upfront.
- Prepaid Rent: Paying rent for multiple future months at once.
- Annual Subscriptions: Paying for a year's subscription to a trade journal or software service.
- Advance payment for services: Paying for an advertising campaign that will run over the next few quarters.
3. Why are prepaid expenses considered a current asset and not an immediate expense?
Prepaid expenses are treated as a current asset because they represent a future benefit or service that the company is entitled to receive. According to the matching principle of accounting, expenses should be recognized in the same period as the revenue they help generate. Since the benefit of a prepaid expense will be consumed in a future period, it is listed as an asset. It is only converted into an expense as the benefit is used up over time.
4. How is the initial journal entry for a prepaid expense recorded?
When a company pays for an expense in advance, the initial journal entry is recorded to reflect an increase in one asset (Prepaid Expense) and a decrease in another asset (Cash/Bank). The entry is:
Prepaid Expense A/c Dr.
To Cash / Bank A/c
This entry correctly shows that the company has simply exchanged one asset (cash) for another (the right to a future service).
5. What is the difference between a prepaid expense and an outstanding expense?
The key difference lies in the timing of payment versus the receipt of benefit. A prepaid expense is an amount paid before receiving the benefit, making it an asset for the business. Conversely, an outstanding expense is an expense for which the benefit has already been received, but the payment has not yet been made, making it a liability for the business.
6. How do prepaid expenses affect the Balance Sheet and the Profit & Loss Account?
Prepaid expenses have a dual impact on financial statements. Initially, they are shown on the asset side of the Balance Sheet under 'Current Assets'. As the benefit of the expense is consumed over time, a portion of the prepaid amount is transferred to the Profit & Loss Account as an expense. This is done through an adjusting entry, which reduces the prepaid asset on the Balance Sheet and increases the corresponding expense in the P&L Account, ensuring profits are calculated accurately.
7. What happens if a prepaid expense is incorrectly treated as a regular expense when paid?
If a prepaid expense is mistakenly recorded as a full expense in the period it is paid, it violates the matching principle. This error leads to an overstatement of expenses and, consequently, an understatement of net profit for that period. In the subsequent period where the benefit is actually consumed, expenses will be understated, and profit will be overstated, distorting the financial performance across both periods.
8. What type of account is 'Prepaid Expense' under the traditional classification?
Under the traditional rules of accounting, a Prepaid Expense account is classified as a Personal Account. More specifically, it is a Representative Personal Account because it represents amounts receivable from the person or entity to whom the advance payment has been made. For financial reporting, it is presented as a Current Asset.
