The concept of \u201cmatching\u201d is one of the basic principles of accrual-basis accounting. It requires companies to match expenses (efforts) with revenues (accomplishments) whenever it\u2019s reasonable or practical to do so. This concept applies when companies make advance payments for expenses that will benefit more than one accounting period. Here are some questions small business owners and managers frequently ask about prepaying expenses.
\nWhen do prepaid expenses hit the income statement?
\nIt\u2019s common for companies to prepay such expenses as legal fees, advertising costs, insurance premiums, office supplies and rent. Rather than immediately report the full amount of an advance payment as an expense on the income statement, companies that use accrual-basis accounting methods must recognize a prepaid asset on the balance sheet.
\nA prepaid expense is a current asset that represents an expense the company won\u2019t have to fund in the future. The remaining balance is gradually written off with the passage of time or as it\u2019s consumed. The company then recognizes the reduction as an expense on the income statement.
\nWhy can\u2019t prepaid expenses be deducted immediately?
\nImmediate expensing of an item that has long-term benefits violates the matching principle under U.S. Generally Accepted Accounting Principles (GAAP).
\nDeducting prepaid assets in the period they\u2019re paid makes your company look less profitable to lenders and investors, because you\u2019re expensing the costs related to generating revenues that haven\u2019t been earned yet. Immediate expensing of prepaid expenses also causes profits to fluctuate from period to period, making benchmarking performance over time or against competitors nearly impossible.
\nDoes prepaying an expense make sense?
\nSome service providers \u2014 like your insurance carrier or an attorney in a major lawsuit \u2014 might require you to pay in advance. However, in many circumstances, prepaying expenses is optional.
\nThere are pros and cons to prepaying. A major downside is that it takes cash away from other potential uses. Put another way, it gives vendors or suppliers interest-free use of your business\u2019s funds. Plus, there\u2019s a risk that the party you prepay won\u2019t deliver what you\u2019ve paid for.
\nFor example, a landlord might terminate a lease \u2014 or they might file for bankruptcy, which could require a lengthy process to get your prepayment refunded, and you might not get a refund at all. Banks also might not count prepaids when computing working capital ratios. And since reporting prepaid expenses under GAAP differs slightly from reporting them for federal tax purposes, excessive prepaid activity may create complex differences to reconcile.
\nWith that said, your company might receive a discount for prepaying. And companies without an established credit history, that have poor credit or that contract services with foreign providers, may need to prepay expenses to get favorable terms with their supply chain partners.
\nFor more information
\nStart-ups and small businesses that are accustomed to using cash-basis accounting may not understand the requirement to capitalize business expenses on the balance sheet. But matching revenues and expenses is a critical part of accrual-basis accounting. Contact us with any questions you may have about reporting and managing prepaid assets.
\n\u00a9 2019<\/p>\n","protected":false},"excerpt":{"rendered":"
The concept of \u201cmatching\u201d is one of the basic principles of accrual-basis accounting. It requires companies to match expenses (efforts) with revenues (accomplishments) whenever it\u2019s reasonable or practical to do so. This concept applies when companies make advance payments for expenses that will benefit more than one accounting period. Here are some questions small business […]<\/p>\n","protected":false},"author":3,"featured_media":0,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"footnotes":""},"categories":[13],"tags":[],"class_list":["post-14277","post","type-post","status-publish","format-standard","hentry","category-aa"],"_links":{"self":[{"href":"https:\/\/www.sfw.cpa\/news-and-guides\/wp-json\/wp\/v2\/posts\/14277","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/www.sfw.cpa\/news-and-guides\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/www.sfw.cpa\/news-and-guides\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/www.sfw.cpa\/news-and-guides\/wp-json\/wp\/v2\/users\/3"}],"replies":[{"embeddable":true,"href":"https:\/\/www.sfw.cpa\/news-and-guides\/wp-json\/wp\/v2\/comments?post=14277"}],"version-history":[{"count":0,"href":"https:\/\/www.sfw.cpa\/news-and-guides\/wp-json\/wp\/v2\/posts\/14277\/revisions"}],"wp:attachment":[{"href":"https:\/\/www.sfw.cpa\/news-and-guides\/wp-json\/wp\/v2\/media?parent=14277"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/www.sfw.cpa\/news-and-guides\/wp-json\/wp\/v2\/categories?post=14277"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/www.sfw.cpa\/news-and-guides\/wp-json\/wp\/v2\/tags?post=14277"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}