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Prepaid expenses are one way to help you manage your cash flow more effectively and ensure that you're not overspending or leaving money on the table. After all, a shortage of cash can affect your company’s ability to pay bills on time, not to mention impact your bottom line. 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. Some examples of prepaid expenses include:

  • Rent 
  • Insurance
  • Taxes
  • Subscriptions
  • Utilities
  • Leased equipment

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. According to Generally Accepted Accounting Principles (GAAP), prepaid expenses are considered current assets since they a business has already paid for them and they represent future economic value. 

The importance of prepaid expenses in small business

Prepaid expenses are a great way to manage your cash flow and budget more effectively. By paying expenses ahead, you can better understand and predict how much money you'll have and when. This, in turn, 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 current 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, because you’ll have a much better sense of your cash flow with your ongoing expenses deducted from it. If, for example, you have a good idea of how much you’ll have left over after rent, utilities, insurance and leased equipment, you can invest that money back into, say, your company’s physical plant. 

7 examples of prepaid expenses

Now that you understand how prepaid expenses work, let's delve more deeply into some common examples.

1. Utilities

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.

2. Rent

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.

3. Leased equipment

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.

4. Insurance

Businesses often purchase prepaid insurance policies in advance to cover their operations for a set period. The full cost is recorded as a current asset on the balance sheet until the policy is used and adjusted to reflect the amount incurred.

5. Software subscriptions

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.

6. 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.

7. 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's used.

How do prepaid expenses work in accounting?

When you pay for a prepaid expense, the cost is recorded as a current asset on your balance sheet in the form of a journal entry during a particular accounting period. This means it'll 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 prepaid asset should be reduced, in the form of a debit, by the same amount and classified as an expense on the income statement in a later accounting period, a process called amortization.

For example, let's say you prepaid your rent for six months. You would make a journal entry in which you record the total amount of the rent expense on the balance sheet as a prepaid asset. Then, as each month passes, you can debit 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 make sure 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 record prepaid expenses on 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 (reflecting its amortization). You should also create an expense account in your income statement and enter a corresponding journal 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.

Benefits:

  • 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.
  • Prepaid expenses make it easier to manage taxes. Your company can reduce its tax liability and plan ahead more effectively by prepaying taxes.

Challenges:

  • 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 can lead to errors in financial reporting, which could have severe implications for your business.
  • Prepaid expenses can 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

Prepaid expenses—as with any other type of business expense—can be time-consuming to organize and track. At Ramp, we understand this, and have built an industry-leading platform that simplifies and expedites the expense management process. 

Ramp’s software automates the tasks around expense management and gives you real-time, AI-driven insights into your financial status, from spending to cash flow. What’s more, 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. 

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Content Lead, Ramp
Fiona writes about B2B growth strategies and digital marketing. Prior to Ramp, she led content teams at Google and Intercom. Fiona graduated from UC Berkeley with a degree in English. Outside of work, she spends time dreaming about hiking the Pacific Crest Trail one day.
Ramp is dedicated to helping businesses of all sizes make informed decisions. We adhere to strict editorial guidelines to ensure that our content meets and maintains our high standards.

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