When should you record the expense when you’ve paid for a whole year up front?
The problem with booking an entire year’s expense when paid is that you are in violation of one of the basic principle of accounting called “Matching”. This principle says that an expense should be recorded in the period in which it was incurred to properly match it up with that period’s revenue. This way our financial statements more accurately reflect the financial position of the company.
The mistake that most people make is that they book the entire year’s premium to Insurance Expense when they pay it. This doesn’t really accurately reflect what is happening though. What is really happening is that we are pre-paying for an expense. We are paying now for something that we are going to get a benefit for each and every month for the next 12 months. Specifically we will be covered. So the more accurate accounting on this is to show the expense evenly over the 12 months and the way to do this is to record it as an asset. A prepaid expense is an asset because we’ve paid for something that we haven’t received the benefit for just yet. Then we record a journal entry each month to record the expense and reduce the pre-paid expense. This can be automated so that you don’t have to worry about it every month – once you set it up, QuickBooks will do the work for you.
Watch the video and if you have any questions, comments, or suggestions please post them below.
Thanks for this video. It was really helpful.
But I have a question: How do you deal with prepaid income.
Same way?
If you are thinking of when you receive income in advance, I have a blog post on that:
Customer Deposits
Hi Seth
Another great video.
I can only remind people that you really need to figure out how accrual vs cash you want to go. And one of the things my CPA taught me, is how relevant it is.
Luckily, with Quickbooks automating so much of it, it isn’t as hard as it was in the bad old manual bookkeeping days.
Still remember how often you actually want to look at the Company Snap Shot, and how much money is involved in relation to the Total Income/Expenses.
Lisa
Thanks Lisa. I try and explain to people that EVERY business is truly running on an accrual basis. Try running a business without posting any bills or invoices? That would be the only way to urn a business on a “Truly” cash basis. You would have no accounting for receivables or payables and a pre-paid expense should technically just get right into the expense account. There would never be any pre-paid anything – incurred entirely and only when paid!
I found the video on prepaids very helpful, However, I have a problem with monies being in prepaid General Journal and not applied to the inventory items when they were received. The inventory items were entered as an inventory adjustment and not against a purchase order, item receipt or bill. How can I get the prepaids reduced and and the monies applied properly. I also have 2 items in Vendors which have item receipts entered, so the inventory is in the inventory. If I create a bill for these items, how do I pay them when the money is in the General Journal (prepaids). Trying to tie the 2 items together without messing up inventory or any other account they may hit. Can you help?
Thanks
The simple answer to this is that you record the bill with items received and then you post another journal entry pulling the money out of pre-paid and and apply it to Accounts Payable (Credit pre-paid inventory and debit accounts payable). This will produce a credit which can then be applied to the bill to show the pre-paid portion as now paid and of course the bill itself will bring your inventory balances up to the right levels now that you actually do have them in inventory.
If you need additional help I can log in remotely with you and teach this to you. Call me (866) 945-8070 and I can arrange it with you.
Also if you want an easier way (without having to post journal entry) then have a look at this post I did on How to record your inventory purchases in QuickBooks In that video I cover pre-paid inventory specifically.
This was great to the point and using the one pre-paid expense account was a good tip to keep the BS neat
Hi, thanks for the instruction on prepaid expenses. Works, but not ideal fir tracking the information under the specific vendor. We use QB and Simply in our office and Simply handles prepaids properly and way easier, hands down.
Another entry we struggle with in QB is prepaying a required fee like a retainer to a lawyer. The lawyer has not billed yet, so there is no bill to enter. How would you enter a retainer paid to a lawyer that you will later offset against the bill you get from the lawyer.
Ex: pay lawyer on May 5 , a retainer of $1000.00. You cannot expense to legal as the service has not been provided yet. So the amount needs to sit in a asset account. Then 6 weeks later in June you receive a bill from the lawyer for $3000.00. (less the 1000 down) you owe 2000, but want to expense the full 3000 to legal and apply your retainer zeroing out the prepaid asset.
Again, Simply handles this easily and quickly all within vendors, no separate journal entries needed.
I would handle pre-paid legal fees in the same manner. By recording the initial payment to an asset account (call it Pre-paid legal fees) and then book the monthly journal entries in the same manner.
In both cases if tracking it by vendor is important to you then what you can do is post a monthly bill (memorized) for 1/12 of the annual and then book the journal entry to close A/P instead of to the expense account (the bill hits the expense account now). This way you have it tracked by vendor and you use the journal entry to show the bill as paid. Not as efficient – it’s more work but it will get you were you want to be in this case.
Seth,
The only problem I’m having with setting up prepaid assets occurs when I run a cash P&L. When you make the JE to credit the prepaid expense that amount hits both the accrual and cash P&L even though there was not any cash paid during that period. Is that a limitation within QuickBooks or is there a way to work around that or am I misunderstanding this completely?
Thanks,