If you are a small business owner, you’ve probably wondered if prepaying expenses is a good idea. But the answer to that question may surprise you. The concept of prepayment is a valid one, and it may even benefit you in the long run. It’s simple accounting: prepaid expenses first appear in the current year, and cannot be recorded as revenue. As a result, they increase in value while cash/bank balances decrease. But when the expense is used, the amount of prepaid expense is credited to the current year.
Many firms set aside money for goods or services before receiving them. Employee labor is one example of a prepaid expense. Companies record employee labor in a prepaid salaries account until they pay the workers. Other types of expenses can also be prepaid. These items can appear as prepaid expenses on a balance sheet, though they are usually recorded in separate accounts. But how do they affect the value of a business? Here are some reasons why companies should consider prepaid expenses:
Prepaid expenses are generally classified as assets, since they are paid in advance. As a result, they begin as assets on the balance sheet, and then turn into an expense in a later period. In this way, prepaid expenses provide a buffer against unexpected expenses and allow businesses to plan ahead for the unexpected. As a result, prepaid expenses are often used for insurance policies and other future-dated assets. In the long run, prepaid expenses can make a significant impact on your bottom line.
Managing prepaid expenses is very simple. The process involves recording the prepaid expense as an asset, and using it up through your monthly expense. In most cases, this expense is automatically reduced by your accounting software. Alternatively, you can use spreadsheets to calculate the monthly expenses you incur. But in many cases, this process is not as straightforward as you might think. If you do it manually, you’ll be surprised at how simple it can be!
When calculating prepaid expenses, it’s important to keep in mind the time value of the prepaid expense. For example, if a business pays $18,000 in December for liability insurance, that same amount will be recorded as an expense on the balance sheet on 31 December 2016. As the prepaid expense account decreases, the value of the insurance policy is recognized, and the prepaid expense is deducted from cash. The company’s income statement will reflect this fact.
For example, you may pay rent for a year. In this case, you would record the entire sum as an asset on your balance sheet, and pay your rent in advance. For the first month, you’d deduct the same amount from your prepaid expenses account, and transfer that money to the rent expense line on your income statement. Then, as you go about your business, you’ll have a total of $24,000 in prepaid expenses and no cash in the bank.