In the course of business, it is sometimes necessary to make advance payments for expenses that fall into more than one accounting period. With accrual-basis accounting, companies implement “matching,” where the company aligns expenses (efforts) with revenues (accomplishments) in the period incurred (this is called the matching principle). To clarify this process for small business owners and managers, here’s a short list of frequently asked questions and answers about prepaying expenses. Please note if your small business is on the cash basis, this does not apply.
When do I enter prepaid expenses on the income statement?
If you’re like most businesses, you may have to pay upfront for goods and services you will use over time, such as legal fees, advertising, insurance premiums, and rent. You can’t immediately report the bulk of that payment on your income statement as an expense when using accrual accounting. Rather, you recognize the expenditure as a prepaid asset on your balance sheet, then gradually write off the item over time. For example, if you’ve paid your insurance for six-months, and you prepare an income statement quarterly, you would enter half of the payment on the income statement for the quarter you made the purchase, and half in the subsequent quarter when you consumed the rest of that service.
Why can’t I deduct my prepaid expenses immediately?
If you use accrual accounting, the short answer is “because you can’t.” Let’s admit it makes a degree of sense, but unfortunately it violates the matching principle under U.S. Generally Accepted Accounting Principles (GAAP). But it’s not just that you broke a rule without saying, “Mother, may I?” a full deduction of prepaid assets would have the effect of making your company look less profitable to lenders and investors in that accounting period, which might raise a few eyebrows that you’d prefer to kept level. You don’t need a banker calling your loan or a major investor dumping your stock over an accounting nuance. Then, on later income statements, you’d look too good to be true on paper, which might resemble fraud. Better to avoid confusion and keep to accepted practices for consistent benchmarking of your company’s performance.
When does prepaying an expense make sense?
Prepaying usually only makes sense when a service provider requires you to do so. If you retain an attorney for continued future services, there’s going to be a retainer. An insurance carrier could require months in advance, or at least offer a discounted rate based on six months or a year. However, there are circumstances where prepaying is optional, and you must weigh the pros and cons. On the con side, prepaying dilutes your cash assets, so you won’t have it available for other uses. It’s also similar to prepaying your taxes in that prepaying gives vendors or suppliers interest-free use of your funds. You also have to gauge the risk that the party you prepay won’t deliver. Suppose you prepay a supplier who subsequently files for bankruptcy. But if you can obtain a discount for prepaying, the benefit might outweigh the inconvenience. Just be sure to vet the company your prepaying to make sure they’ll be around for the full period of your contract.
Contact Breon & Associates in Harrisburg
For more detailed guidance tailored to your company’s specific circumstances, consult Breon & Associates. We advise start-ups and small-to-medium businesses on the best use of their limited resources. With offices in Harrisburg and North Central PA, Breon & Associates provides business, accounting and tax services throughout Pennsylvania. Call us at 1-888-516-8476 or 717-273-8626, or contact one of our offices online to schedule an online consultation or an online training event.
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