Prepaid Expense

What does it mean

Prepaid expense represents the amount of money spent to purchase services that have not yet been received.  For example, if you receive a discount from your accountant to prepay your ultimate accounting services in January even through the services aren’t rendered until April, the amount spent in January instead of being shown as an expense in January would be listed on the balance sheet as an asset equal to the amount spent, and then when the services are actually rendered in April, the expense will show up on the income statement and it will wipe out the asset since now the services have been received.  

Why does it matter

Prepaid expenses matter for two primary reasons. 

The first reason is that the amount spent on prepaid expenses factors directly into the amount of cash or available credit a business has on hand. Any extra dollar paid in prepaid, is one less dollar available to be used in the meantime.  Due to this, making sure the borrower has considered other upcoming cash needs between now and when services are rended will be important to make sure the customer doesn’t get into a cash pinch in the meantime.

The second reason is that it will help you to understand how a certain industry works.  I am from Minnesota, and we work with a lot of farmers.  Farmers are allowed to use Cash Accounting when completing their Tax Returns versus Accrual Accounting.  Why this matters is because under cash accounting, you list an expense when it has been “paid” for rather than when it was “incurred.”  Knowing this, then farmers are effectively allowed to manage their tax bill each year.  If they (like most businesses) want a lower tax bill, they can prepay for next years inputs (like seed and fertilizer) which results in their expenses increasing and their income (taxable income that is) to decrease.  Understanding this helps the bank to understand that prepaid expenses plays a large role in this industry.

Other Relevant Terms

• Capital
• Current Assets
• Current Liabilities
• Working Capital
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