Prepaid expenses (RAP) play an important role in accounting and are divided into asset and liability items. Prepaid expenses (ARAP) are future revenues, while deferred income (PRAP) are future expenses.
ARAPs relate, for example, to income from rents or lease payments that have been paid in advance and may not be recorded directly as revenue. PRAPs occur, for example, in the form of salary payments or bonuses that have already been paid but may only be expensed in the future.
In this article, we will explain in more detail what prepaid expenses and deferred income are and how they should be handled correctly in accounting. We will also look at accounting entries and the meaning of balance sheet items.
What is prepaid expenses?
Prepaid expenses is an accounting tool used to defer business transactions from the current fiscal year to the following year. This is done in order to prepare a correct profit and loss statement and to reflect the actual business performance. This is an item on the asset side of the balance sheet that represents advance payments or prepayments on future invoices.
Prepaid expenses can be used, for example, when a company collects annual premiums from customers in December, but they do not have to be provided until the following year. In order to create the correct income statement, this income is recorded in the following year and not already in the current fiscal year.
The entry of prepaid expenses is made on the credit side of the account “Other liabilities”. When the invoice-dependent service is paid, the amount is debited from this account and posted to the corresponding expense accounts.
Deferred income: explanation and accounting
An accrual is an entry on a company’s balance sheet made to allocate expenses or costs incurred in the current fiscal year but not to be paid until a later fiscal year. This is done in order to allow a correct presentation of the actual profit or loss of a fiscal year.
Unlike prepaid expenses, which defer income or revenue to a later period, deferred income recognizes a liability on the balance sheet. This liability must be paid in the following fiscal year.
The accounting of an accrued liability is carried out through the creation of an accrual item. It is necessary to estimate the exact amount of expenses or costs that will have to be paid in the future. This estimate should be based on experience or derived from previous accounting years and should be a realistic assumption of actual costs.
To account for an accrued liability, accruals are created in the balance sheet and expensed in the income statement. The creation of accruals is an important part of accounting and should be carefully planned and executed to avoid a distorted presentation of a company’s financial position.
Accruals: Definition and correct handling
Accruals are an important accounting method for allocating expenses and revenues across multiple accounting periods. A distinction is made between accrued expenses and deferred income.
Deferred income relates to expenses that have already been paid but have not yet been consumed or used. This includes, for example, advance payments such as rents or leasing contracts. Prepaid expenses, on the other hand, refer to revenues that have already been received but cannot be used until a later date.
To handle accrued expenses correctly, they must be recorded as liabilities in the accounting system. Prepaid expenses, on the other hand, are recorded as receivables. It is important that the allocation of expenses and revenues to the respective accounting periods is done correctly and that the figures are reported correctly in the corresponding financial statements.
Thus, when correctly handling prepaid expenses, it is particularly important to pay attention to the correct recording in the accounts and to correctly allocate expenses and revenues to the respective periods. Careful documentation is essential here to ensure accurate reporting in the financial statements.
- Deferred income: record as a liability
- Prepaid expenses: record them as receivables
- Correct allocation to accounting periods
- Careful documentation for accurate reporting in financial statements