Cash flow is a significant issue for businesses big and small. In fact, according to a recent survey, 61% of business owners report that cash flow is their biggest challenge. Without proper management and understanding of how to handle your expenses, this can be an even bigger problem. Not only can it affect your ability to pay bills on time, but it also impacts your bottom line.
Prepaid expenses are one way to help manage cash flow more effectively and ensure you're not overspending or leaving money on the table. In this guide, we'll cover what prepaid expenses are, how to manage them, and why they should be a part of your budgeting and accounting strategy.
What are prepaid expenses?
Prepaid expenses are expenses that are paid in advance before the actual costs are incurred. These expenses can be either one-time payments or ongoing commitments. Examples include rent, insurance, taxes, and subscriptions.
Prepaid expenses are common in most businesses and are usually tracked separately from other costs. This is because prepaid expenses are treated differently for accounting purposes than regular expenses.
The importance of prepaid expenses in small business
Small businesses rely on cash flow to keep operations running smoothly. Prepaid expenses are a great way to manage your cash flow and budgeting more effectively. By paying expenses ahead, you can better understand and predict how much money you will have and when. This can help you track your spending and allocate funds for upcoming expenses.
When you calculate prepaid expenses correctly, you can also better plan for tax season. Since these expenses are considered assets, they can create a tax deduction and help reduce the money you owe during filing.
Tracking these expenses can also help you determine how much money you can reinvest into your business. For example, if you've budgeted for a certain amount of prepaid expenses, it could allow you to invest additional funds into growing the company.
Examples of prepaid expenses
Now that you understand how prepaid expenses work, let's look at some common examples.
Utilities like electricity, water, and gas that you pay for in advance are considered prepaid expenses. While many businesses use monthly payment plans, some may prepay for longer periods to reduce their costs. An example of a prepaid utility is an annual contract for electricity.
Businesses often prepay their rent to secure their space for a set period of time. This allows them to lock in the rental rate and avoid any potential increases due to market fluctuations during that period.
Leases on machinery and other equipment are also considered prepaid expenses. These costs are typically spread out over the duration of the lease, with a portion being recognized monthly as an expense. For example, a business may lease a copy machine for three years and pay for it upfront. Each month, the cost of the copy machine will be recognized as an expense in their income statement.
Businesses often purchase insurance policies in advance to cover their operations for a set period. The cost is recorded as an asset until the policy is used and adjusted to reflect the amount incurred.
Software subscriptions like cloud storage and web hosting are also considered prepaid expenses. Many software companies offer monthly or annual subscriptions that businesses can prepay to save money in the long run.
Taxes paid in advance
Any taxes paid in advance of the due date are considered prepaid expenses. This includes estimated taxes, sales taxes, and other applicable taxes. By prepaying, you can reduce the amount of taxes due at the end of the year and save money in interest and penalties.
Supply orders in stock
Any supplies, such as inventory or raw materials, purchased in advance and stored on-site are considered prepaid expenses. Businesses often buy these items to ensure enough supply when demand increases. For example, you may place bulk orders of office supplies to get better pricing. By prepaying, your business will record the cost when the order is placed rather than when it is used.
How do prepaid expenses work?
When you pay for a prepaid expense, the cost is recorded as an asset on your balance sheet. This means it will appear as one of your company's assets and increase its total value. However, when the service or product is used or consumed, the corresponding asset should be reduced by the same amount and classified as an expense on the income statement.
For example, let's say you prepaid your rent for six months. You would record the total amount on the balance sheet as an asset. Then, as each month passes, you can reduce this asset by one-sixth of the total cost and recognize it as an expense on the income statement.
How to identify and calculate prepaid expenses
Identifying and calculating prepaid expenses can be tricky, but you can consult your accountant or bookkeeper to walk you through the process. If you’re a sole proprietor and don’t work with an accountant, there are several steps you can take to ensure you get it right.
First, review your current expenses, invoices, and statements for any items paid in advance. Then determine what type of expense it is, either one-time or ongoing, and calculate the amount that needs to be recognized as an asset and expense each month.
Once you've determined the total amount of prepaid expenses, creating a system for tracking them regularly is crucial. This will help you ensure that your financial statements stay current and avoid potential accounting errors. You should also review the costs each quarter or at least once a year to make sure they are still accurate and up to date.
How to log prepaid expenses in your balance sheet
Logging your prepaid expenses in the balance sheet can help you accurately track these costs and maintain accurate financial records. To record a prepaid expense, create a new asset account with an appropriate title to distinguish it from other assets. Then, enter the total amount you paid for the expense and post the transaction to your balance sheet.
When the prepaid expense is used or consumed, reduce the asset account by that amount. You should also create an expense account in your income statement and enter a corresponding entry to reflect when the cost was incurred.
Ramp's accounting automation solution makes it easy to log, track, and manage all your prepaid expenses. With real-time data, you'll always have accurate financial statements that reflect the current state of your finances.
Benefits and challenges of prepaid expenses
Prepaid expenses can benefit businesses struggling to make ends meet. However, there are some pitfalls to be aware of.
- Prepaid expenses can help small businesses and startups manage their cash flow. By paying for costs in advance, you can reduce the immediate impact on your balance sheet, allowing you to cover short-term expenses more easily. This is especially helpful for those with limited access to other forms of financing.
- Prepaid expenses can help businesses secure discounts and better pricing. Many suppliers offer discounts for prepayment, enabling enterprises to reduce their costs and improve their profit margins.
- Prepaid expenses can also help businesses prepare for unexpected events. With a sufficient amount of prepaid expenses in your accounting system, you can cover unanticipated costs that arise.
- It's easier to manage taxes when you pay for expenses in advance. Your company can reduce its tax liability and plan ahead more effectively by prepaying taxes.
- Since prepaid expenses are recorded as assets, they can reduce the capital available for operations. This could strain businesses that depend on cash reserves to cover day-to-day costs.
- Without the right software or accounting system, tracking and adjusting the value of prepaid expenses can be challenging. This could lead to errors in financial reporting, which could have severe implications for your business.
- Prepaid expenses can also limit businesses' flexibility when it comes to spending. If your plans change and you need to use those funds for something else, you may be unable to do so.
Control every expense with Ramp
At Ramp, we understand the challenges businesses face around prepaid expenses. That's why we offer an intuitive platform that simplifies and streamlines the process of managing your expenses.
Our comprehensive vendor management solution lets you easily negotiate better deals with vendors and organize expenses to get the most value from every dollar you spend. Plus, with spend management, you'll get real-time visibility into your finances so you can make informed decisions and stay on top of your expenses. When you reduce prepaid and other expenses, you can devote more resources to areas essential for business success.
Ready to give your prepaid expenses a boost? Contact Ramp today, and let us help you optimize your finances for success.
Prepaid expense amortization is the process of allocating expenses over a period of time. This allows businesses to spread out the costs associated with an expense and recognize them as assets on their balance sheet.
Yes, prepaid expenses are classified as current assets because they are expected to be used up within one year.
Prepaid means that a business has made an advance payment for goods or services that it has not yet received.
The most common prepaid expense is rent, typically paid in advance of the period it covers.
Prepaid expenses are payments made before receiving goods or services, while prepaid income is money received in advance of providing goods or services.
The 12-month rule for prepaid expenses states that the amount of an expense must be recognized in the accounting period during which you expect it to be used or within the next 12 months. This ensures that businesses don't overstate their assets on their balance sheet.