Prepaid expenses are classified as an asset on a company's balance sheet since their balance represents a benefit that will be used in future periods. To avoid misstatements to a company's financial statements, it is important that the account is reconciled each month.
Types of Prepaid Expenses
Amounts that comprise the prepaid expense balance on a company's balance sheet at period-end include, but are not limited to, prepaid insurance premiums, prepaid rent, property taxes and prepaid service contracts. The payment is recorded as an asset at the time of payment and as the benefit is consumed, the balance continues to decline.
Read More: Difference Between Deferred Charges & Prepaid Expenses
Example of Prepaid Expenses
The impact to the income statement and balance sheet when prepaid expenses fail to be properly adjusted can best be understood with an example. Assume that on Jan. 5 a company that designs and manufactures t-shirts purchases a 12-month maintenance agreement for two of the machines used in production. The agreement costs $9,600, begins on Feb. 1 and expires Jan. 31 of the following year.
Recording the Asset
Since the purchase was made in January, the following entry will be made by the company's bookkeeper by Jan. 31: Debit prepaid expenses $9,600 Credit cash $9,600 Note that since the usage on the agreement has not occurred yet, this entry only impacts the balance sheet.
Since the contract has a total cost of $9,600 for a 12-month service period, the company will expense $800 each month to the maintenance and repairs account. The recurring monthly entry recorded by the company's bookkeeper is as follows: Debit repairs and maintenance expenses $800 Credit prepaid expenses $800 With a credit to the asset account of prepaid expenses, this entry will continue to consume the asset over the agreement period until the balance is zero at the end of the contract period.
Failing to Record the Entry
On May 21, the company's bookkeeper realizes that he has failed to book the monthly entry to prepaid expenses since the time the contract began. This means that each month, the company's expenses have been understated by $800 resulting in overstated income of the same amount. It also means that the prepaid expense asset account on the company's balance sheet has been overstated for three months by a total of $2,400.
Making the Correction
To correct her error and "catch up" for February through May, the bookkeeper makes the following entry at month-end: Debit repairs and maintenance expenses $3,200 Credit prepaid expenses $3,200 The bookkeeper then explains to the owner that while repairs and maintenance for the month of May appears to be very high, it is the result of booking four months at once and from failing to expense the amount for the last four periods.