Getting help from a professional tax preparer is paramount if you want to benefit from tax advantages when filing income tax return. Claiming Tax Deductions for Expenses that are Prepaid. Needless to say, tax deduction of prepaid expenses is not simple. The tax laws are complex and do not offer much help.
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Prepaid expenses are any money your company spends before it actually gets the goods or services you're paying for. Prepaid revenue – also called unearned revenue and unearned income – is the reverse; it's money someone pays your company in advance of you doing the work. When you make out the company financial statements, you have to put prepaid expenses and revenues in their own accounting categories.
Tip
When a business pays for services or goods in advance, it is a prepaid expense. When a company is paid before performing the work, that's prepaid revenue. They both go on the balance sheet, but in different accounts under prepaid expenses on the asset side and unearned revenue on the liability side.
What Are Prepaid Expenses and Prepaid Revenue
Business isn't always a matter of 'Do the work; get paid the money.' Suppose you work in construction or remodeling. If you contract for a major job, it's common to ask the customer for an upfront deposit. That money is unearned revenue until you start the work that will earn it. In other industries that involve regular monthly services, you might offer a discount if, say, the customer prepays for the next six months.
Prepaid expenses are when your company does the same thing. You pay your insurance for the year on January 1, or pay for the next six months of office cleaning services ahead of time.
The Accounting Problem
If you treat prepaid expenses or revenue like regular revenue, that creates a distorted picture of your finances. Suppose you receive $60,000 in January for services over the coming year. If you report all the income in January, it will make you look very successful – followed by 11 months when you don't get any income from the work. Treating prepaid amounts differently from regular income gives anyone reading your income statement or balance sheet a better perspective.
Prepaid Expenses on the Balance Sheet
The balance sheet is an 'equal sign' with company assets on one side, liabilities plus owners' equity on the other. It shows readers the value of your assets – cash, real estate, equipment – and how much the company would be worth after you pay off all your debts. You include prepaid expenses on the asset side of the equation.
For example, suppose you pay your office-cleaning contractor $2,400 in advance for the next six months of cleaning. What you've really done is exchange one asset – $2,400 in cash – for $2,400 worth of services. You shift $2,400 out of Cash on the balance sheet and report $2,400 as a Prepaid Expense instead. Every month, when you get the work you paid for, you reduce the prepaid expense entry by $400. You also enter a $400 expense on your income statement.
Unearned Income on the Balance Sheet
Prepaid revenue might feel like an asset, but to accountants, it's a liability. Say you're shipping $10,000 worth of computer equipment to a new customer overseas and you want the money in advance. Once you receive it, this creates a debt – you owe the customer $10,000 worth of tech – so you have a liability. You report the $10,000 in Unearned Revenue in the liability section of the balance sheet, as well as in Cash on the asset side. When you deliver the goods and earn the money, you erase the $10,000 in Unearned Revenue and report $10,000 in revenue on the income statement.
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About the Author
Fraser Sherman has written about every aspect of business: how to start one, how to keep one in the black, the best business structure, the details of financial statements. He's also run a couple of small businesses of his own. He lives in Durham NC with his awesome wife and two wonderful dogs.
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Businesses make advance payments for a variety of different expenses. Any expense that is paid in advance of actually receiving the benefit of the payment is considered a prepaid expense for accounting purposes. Prepaid expenses are recorded on a company’s balance sheet as a current asset, and then recognized as an expense when it is incurred. There are many categories of prepaid expenses including legal fees, insurance premiums and estimated taxes.
Commercial Lease Rent
If a commercial lease agreement requires the prepayment of the last month’s rent or payment of any months in advance, that expense should be posted to the prepaid rent account. If the monthly rent payment is issued in the last week of the previous month, this expense should also be posted to prepaid rent until the month begins. The amount should be posted as a debit to prepaid rent and a credit to cash. Once the new month starts, relieve the prepaid by posting a credit to the prepaid rent account and a debit to the rent expense for the monthly rent amount.
Indemnity and Other Insurance
Most corporate insurance policy premiums are paid in full for the year before the policy year begins. Prepaid insurance premiums are classified as a current asset, because their benefit will be realized in full within the next 12 months. When you pay the insurance premium, post the prepaid expense as a debit to a prepaid insurance account and then credit the cash account. This increases the prepaid account and decreases cash.
During each month’s closing cycle, relieve the prepaid for the applicable amount, which you can determine by dividing the premium by the number of months it applies to. Credit the prepaid insurance account and debit the insurance expense account for this amount to recognize the expense.
Bulk Orders of Supplies
Bulk orders of supplies produce a stock that is an asset until they are used. Any supply orders that are placed into that stock can be recorded in a prepaid account. Debit the prepaid account for the amount that is added to stock, and credit the cash account to reflect the purchase. During each month's closing process, credit prepaid supplies for the estimated amount of supplies utilized during the month, and debit the supplies expense account.
Quarterly Estimated Taxes
The quarterly estimated taxes paid by corporations throughout the year are a prepaid tax, because they are an estimated payment made in advance of the actual tax liability. Although businesses recognize the expenses associated with a tax liability throughout the year using payable accounts such as payroll tax payables, the actual quarterly estimated payment is recorded as a prepaid expense until the end of the year’s final tax payment is issued.
Debit the prepaid tax account for the amount of the payment, and then credit cash to recognize the reduction in the cash account. Credit prepaid taxes and debit the tax expense account when the actual liability amount is calculated at the end of the year.
Retainer for Legal Expenses
Paying a retainer fee to an attorney is an advance payment toward legal services that the company has a reasonable expectation of incurring. Most attorneys require that clients pay a retainer upfront upon accepting a case. Debit a prepaid legal account with a credit to the cash account for the amount of the retainer. When the legal services are rendered, expense the retainer with a credit to prepaid legal and a debit to the legal expenses account.
Anything Paid in Advance
Any business contract agreements that require a deposit or payment in advance are prepaid expenses. Debit the related prepaid account for the amount of the advanced payment, and credit the cash account for an equal amount. When the services are rendered or the expense is incurred, credit the prepaid account and then debit the corresponding expense account in the ledger.
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About the Author
Tara Kimball is a former accounting professional with more than 10 years of experience in corporate finance and small business accounting. She has also worked in desktop support and network management. Her articles have appeared in various online publications.
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