Prepaid expense is typical operating cost that have been paid before maturity. In other words, the company has made a cash payment but has not recognized it as an expense in the income statement. Such recognition is possible in accrual accounting in which the company recognizes the expense when it occurs, regardless of whether the company has paid or not.
Presentation of prepaid expense in financial statements
Under the principle of matching, companies do not record prepaid expenses as expenses in the income statement at the time of payment because they relate to future expenses. Instead, the company records it as assets in the balance sheet. Over time, the company deducts the value and recognizes the deduction as an expense on the income statement.
The company report it as a current asset when it relates to costs expected to be incurred in the next 12 months. And, it is classified as non-current assets when it exceeds 12 months.
Examples of recognition
Say, at the beginning of the year, a company pays Rp80 as a down payment for one-year office rent. When this happens, the company records cash disbursements of Rp80 and records prepaid expenses of Rp80. Both are the assets’ items, so that total asset is unchanged.
At the end of the first quarter, the company recognized a three-month lease of Rp20 as rental expense in the income statement. And, the company also deducts prepaid expenses in the balance sheet at an equivalent amount. The accounting equation remains balanced because of assets (prepaid expense accounts) and equity (on the retained earnings component) decrease by Rp20.
At the end of the year, the company recognizes an expense of Rp80 on the income statement and the balance of the prepaid rent account will be zero.
In addition to office leases, some examples of prepaid expenses are insurance policies, salaries, taxes, and utility bills.