Are prepaid expenses an asset?

Prepaid expense means a service to be rendered in the future period for which the business has already paid the remuneration. Prepaid expenses are classified as assets. The benefits of this payment will accrue to the business at a later period. 

For example, insurance is often paid for annually on the basis of the calendar year. A business may pay insurance every year on 1st January for that entire year. While preparing the financial statements on 31st March, it will recognize the insurance premium for the period 1st April to 31st December of the next financial year as a prepaid insurance expense. 

Why are prepaid expenses classified as assets? 

First of all, let us understand what an asset is. An asset is anything over which the business has ownership rights and which it can sell for money. The benefits of this asset should accrue to the business. 

In light of this definition, let us analyze prepaid expenses as an asset. As the business has already paid for these goods or services, it becomes a legal right of the business to receive the relevant goods or services at a later date. As the benefit of this expense would accrue to the business only at a later date, the prepaid expenses are classified as an asset. 

Some examples of prepaid expenses are prepaid insurance, prepaid rent etc

Treatment of Prepaid Expenses

Prepaid expenses are recorded in the balance sheet under the heading “Current Assets” and sub-heading “Other Current Assets”

As per the Generally Accepted Accounting Principles or GAAP, expenses must be recognized in the accounting period to which they relate or in which the benefit due to them is likely to arise. Thus, we cannot recognize the prepaid expenses in the accounting period in which they are incurred. 

Prepaid assets are classified as assets and carried forward in the balance sheet to be debited in the income statement of the accounting period to which they relate. 

Adjusting Entries

Adjusting entries are those entries that are used to recognize prepaid expenses in the income statement of the period to which they relate. These entries are not used to record new transactions. They ensure compliance with GAAP by recognizing the expenses in the period to which they relate. 

Conclusion

The GAAP and basic definition of an asset govern the treatment of prepaid expenses as an asset. The business incurs them in an accounting period different from the accounting period in which their benefit would accrue to the business. The business has a legal right to receive those goods or services. 

The business carries them as a current asset on the balance sheet. In the relevant accounting period, they are recognized in the income statement.