The concept of “matching” is one of the basic principles of accrual-basis accounting. It requires companies to match expenses (efforts) with revenues (accomplishments) whenever it’s reasonable or practical to do so. This concept applies when companies make advance payments for expenses (prepaid expenses) that will benefit more than one accounting period.
Here are some questions that small business owners and managers frequently ask us about prepaid expenses.
It’s common for companies to prepay such expenses as legal fees, advertising costs, insurance premiums, office supplies, and rent. Rather than immediately report the full amount of an advance payment as an expense on the income statement, companies that use accrual-basis accounting methods must recognize a prepaid asset on the balance sheet.
You may have encountered the question—is a prepaid expense an asset? Yes, a prepaid expense is an asset that represents an expense the company won’t have to fund in the future. The remaining balance is gradually written off with the passage of time or as it’s consumed. The company then recognizes the reduction as an expense on the income statement.
Immediate expensing of an item that has long-term benefits violates the matching principle under U.S. Generally Accepted Accounting Principles (GAAP).
Deducting prepaid assets in the period they’re paid makes your company look less profitable to lenders and investors, because you’re expensing the costs related to generating revenues that haven’t been earned yet. Immediate expensing of prepaid expenses also causes profits to fluctuate from period to period, making benchmarking performance over time or against competitors nearly impossible.
Some service providers—like your insurance carrier or an attorney in a major lawsuit—might require you to pay in advance. However, in many circumstances, prepaying expenses is optional.
There are pros and cons to prepaying. A major downside is that it takes cash away from other potential uses. Put another way, it gives vendors or suppliers interest-free use of your business’s funds. Plus, there’s a risk that the party you prepay won’t deliver what you’ve paid for.
For example, a landlord might terminate a lease—or they might file for bankruptcy, which could require a lengthy process to get your prepayment refunded, and you might not get a refund at all. Banks also might not count prepaid expenses when computing working capital ratios.
Also, a prepaid expense is an asset that is treated differently under GAAP than most other assets. Since reporting prepaid expenses under GAAP differs slightly from reporting them for federal tax purposes, excessive prepaid activity may create complex differences to reconcile.
With that said, your company might receive a discount for prepaying. And companies without an established credit history, that have poor credit or that contract services with foreign providers, may need to prepay expenses to get favorable terms with their supply chain partners.
Start-ups and small businesses that are accustomed to using cash-basis accounting may not understand the requirement to capitalize business expenses on the balance sheet. But matching revenues and expenses is a critical part of accrual-basis accounting. A prepaid expense is an asset that should generally be handled by accounting professionals in order to abide by the best principles and practices.
Maxwell Locke & Ritter has decades of experience helping businesses of all sizes with accounting, tax advice, and other financial needs. Contact us with any questions you may have about reporting and managing prepaid expenses.