Pre-3/4 - Lesson 2 - Prepaid Expenses Flashcards
What is a prepaid expense? Provide an example of one in a business setting.
A prepaid expense is a cost that a business pays in advance for goods or services to be received in the future. An example is paying for insurance coverage for the next six months in one upfront payment.
Why might a business pay for expenses in advance rather than as they occur?
Businesses might pay for expenses in advance to secure services or discounts, manage cash flow better, or ensure uninterrupted access to essential services, like rent or insurance.
How would a prepaid expense initially be recorded in a business’s accounting records?
Initially, a prepaid expense is recorded as an asset because it represents a future economic benefit for the business. As the benefit is used up, it will be recognized as an expense.
How is a prepaid expense different from a regular expense?
A prepaid expense is paid for before it is used, while a regular expense is paid for at the time it is used or after. Prepaid expenses are recorded as assets initially, whereas regular expenses are recorded directly as expenses.
What are some potential benefits of prepaying expenses for a business?
Prepaying expenses can provide benefits such as securing a service at a locked-in rate, receiving potential discounts, reducing the number of transactions, and ensuring continuous availability of essential resources.
How does paying for an expense in advance affect a business’s cash flow?
Paying for an expense in advance reduces the business’s available cash in the short term, but it provides a benefit that will be realized over time. This upfront cash outflow can be planned for in budgeting.
List three common examples of prepaid expenses a business might have.
Common examples include prepaid rent, prepaid insurance, and prepaid advertising expenses.
Why is a prepaid expense initially considered an asset and not an expense?
A prepaid expense is initially considered an asset because it represents a service or benefit that the business has paid for in advance and expects to use in the future. Only as the service is used or time passes does it become an expense.
If a business pays $6,000 for three months of rent in advance, what type of expense is this considered, and how long will this prepaid expense last?
This payment is considered a prepaid expense because it provides a future benefit, covering three months of rent. Each month, one-third of the $6,000 would gradually be recognized as an expense, reducing the prepaid amount over time.
As time passes, how does the prepaid expense change on the business’s financial records?
As time passes or as the service is consumed, the prepaid expense is gradually reduced and converted into an expense on the income statement, reflecting the benefit being used up. This helps match the cost with the period in which it was incurred.
What is the difference between prepaid rent and rent expense?
Prepaid rent is an advance payment recorded as an asset for future benefit, while rent expense is the cost recognized as it is incurred within a specific period.
Why is prepaid rent classified as a current asset on the balance sheet?
Prepaid rent is classified as a current asset on the balance sheet because it represents a payment for rent that will provide a future economic benefit within the next 12 months.
