In our previous series of blog posts about preparing for, filing and following up on the year-end for your incorporated or unincorporated small business, we briefly touched on how to account for prepaid revenues and prepaid expenses in your books. A number of our readers emailed with questions so we thought we’d explore the topic a bit deeper in this blog post.
What are Prepaid Revenues and Prepaid Expenses?
Prepaid revenues are exactly what the name says – revenue that you receive up front for an on-going supply of products or services. Typical prepaid revenues are support agreements, software subscriptions and extended warranties. In most situations you receive these as a chunk of revenue but provide the deliverables over a period of time.
Prepaid expenses are very similar, but on the expense side of the income statement: they are expenses that you pay up front in one big chunk but you get what you’re paying for over a period of time. The most common prepaid expense is insurance – you typically pay these expenses in one lump sum but you’re insured over a longer period of time.
Why do Prepaid Revenue and Expenses Need Special Treatment?
The issues with prepaid revenues and expenses lies in the lump sum of the payment and the prolonged delivery of whatever was purchased. Depending on the sums of money involved, this can seriously affect your balance sheet and income statement and especially if the delivery period doesn’t line up perfectly with your year-end, which in most cases it won’t.
Consider the case of a business that pays $12,000 per year for commercial insurance. If the business bookkeeper lumped the entire $12,000 expense into one payment, then the monthly income statement would take a huge hit and might even show a loss. Conversely, the following eleven months – which would benefit from the insurance coverage just like that first month would – wouldn’t be affected and might reflect an income when the business is actually running at a loss.
The same applies for looking at quarterly and annual income statements, something that every small business owner should review with their bookkeeper or accountant. If you put the entire $12,000 payment into one quarter then that quarter’s numbers might not look so good whereas the income statements for the following three quarters might look better than they actually are.
When your year-end comes around, the payment for the coverage would fall in the previous tax year, making the income for that year lower, even though the coverage will extend into the new financial year.
Best Practices for Dealing with Prepaid Revenues & Expenses
Continuing with our $12,000 insurance example, instead of putting the entire $12,000 against your insurance expense category when the invoice is paid it is better practice to pay the entire invoice but to create a revenue account for prepaid expenses and debit the entire amount against that account. Then, as time unfolds and those products or services are delivered, expense the appropriate amount against your newly created revenue account.
So, on the day the insurance invoice is paid you would credit your cash account by $12,000 and debit your prepaid insurance expense account by $12,000 (keeping your balance sheet in check) and then at the end of each month you would decrease the prepaid account by $1,000 (the value of the insurance coverage ‘consumed’ during the month) and increase your insurance expense account by the same amount.
How This Helps Your Business
By taking this approach you get a clearer picture of how well your business is performing in any given time period. There are no months on your income statement that have to take a huge hit while other months don’t, even though they’re benefitting from whatever was purchased – all months bear the cost of what was purchased equally. Even though our example has used an expense, the same is still true for revenue: no single month would show a huge profit even though the cost of delivery is spread out over the following months.
How Your Bookkeeper Can Help
A good bookkeeper should help you understand how your business is performing and whether your business is growing, maintaining or shrinking. Your bookkeeper will help you deal with things like making sure your prepaid revenues and expenses are accounted for in your business books in a way that doesn’t distort the picture of how your business is operating so you can make the right decision for the success and growth of your business.
Don’t think of a bookkeeper as someone who simply enters transactions into your accounting software, the true value of a qualified and experienced bookkeeper should help you understand and manage the financial well-being of your business.
Understanding how the financial operations of your business is so important for the success of small businesses, and how you enter your prepaid revenues and expenses can really distort that picture. Instead of incurring revenues and expenses for products and services that will be delivered over time in one lump sum you should use prepaid revenue and expense accounts to spread those revenues or expenses over the life of when they will be delivered.
Simply Bookkeeping1 provides professional bookkeeping services for freelancers, solopreneurs and owners of unincorporated and incorporated businesses. We customize our services based on your needs – we only see some of our clients a few hours a month but others we see on a more regular basis. Our services are reasonably priced and we tightly track the amount of time we spend working for you so you only pay for the services you get.
To learn more about us, please visit our website at www.simplybookkeeping1.com or contact Michele Hyde by phone at (647) 668 – 9363 or by email at firstname.lastname@example.org.
Have Your Say
If you have to deal with prepaid revenues and expenses in your small business we’d love to hear from you! Tell us how you’ve found the best way to deal with them. Also, please share this article using the social media share buttons – chances are there are others out there trying to figure out the same things!