Prepaid expenses

What it means

Prepaid expenses are costs a company paid or booked in the current year that belong in substance to later periods. Typical examples are subscriptions, insurance premiums, rent or licences paid in advance. They are one of the accrual and deferral items and are recorded on account 381.

The reason is the accrual principle: an expense belongs to the period it relates to in substance and in time, not to the period of payment. If a company pays next year’s annual insurance in December, it is not an expense of the current year but an asset that moves into expenses gradually.

Prepaid expenses have their counterpart in deferred income, where a company has received money for work it will perform later. They differ from estimated items in that the amount is known exactly from a document.

How it works in practice

When processing an invoice whose service period runs past year end, we split the amount by month. The part for the current year goes to expenses and the rest to account 381. In the following year we release it to expenses gradually, usually monthly, so that interim results are accurate too.

Before the financial statements we go through the list of contracts with annual or multi-year payments, such as insurance policies, lease agreements, software licences or advertising. The balance on account 381 must be broken down into specific items and periods so that an auditor or the tax office can verify it.

For small amounts that recur every year, a company may skip deferral under its accounting policy if this does not affect the true and fair view. We agree this rule with the client in advance and document it so that it is applied consistently every year.

What to watch out for

A forgotten deferral shifts expenses between years and changes the tax base. With large amounts, such as a three-year licence paid at once, the tax office may reduce the current year’s expenses in an audit and assess additional tax with interest.

Prepaid expenses are not a place to park unwelcome costs. If a company shifted costs that do not belong to the future in this way, it would distort the result and breach the Accounting Act, which in an audit means a fine and restated financial statements.