Meaning of Prepaid Expenses

Prepaid Expenses

Prepaid expenses are necessary, since the balance sheet date for expenses and expenditures and revenues and expenses be timing differences – which means that not all values actually been brought to bear on the balance sheet date. With the accruals and deferrals , the amounts are proportionally correctly allocated to the respective periods.

The procedure for deferred income is regulated in the HGB and the Income Tax Act. In this post, we will show you why the delimitation is necessary, what you have to pay attention to when delimiting, what forms there are and how you can dissolve the delimited items again.

Why are prepaid expenses created?

The core essence of the delimitation is the allocation of the amounts in the correct period . For example, let’s think of an insurance company that sends you an invoice for a year in advance in December . This invoice only affects one month in the current year, but eleven months in the following year. A corresponding deferred income ensures that the amount is also included in your accounting in this relation.

On the one hand, this means that your balance sheet is closer to reality, on the other hand, it also prevents the balance sheet results from being overly controlled by high advance payments. Conscientious entrepreneurs and the tax authorities are therefore equally interested in correct prepaid expenses.

Types of accruals and deferrals

According to HOWSMB, the main distinction between the types of accruals is to be made between active and passive accruals . In addition, a distinction can be made between transitory and anticipatory items , which we will go into in more detail later. It is really important that you understand the differences between active and passive accruals and deferrals for your accounting.

By the way, the active prepaid expenses are abbreviated as active RAP, while the passive ones are abbreviated as passive RAP.

Active accruals and deferrals

In the case of active accruals and deferrals , a payment was made before the balance sheet date, but this partly relates to the next year. Let us recall the example mentioned of prepayment to the insurance company, but other situations can arise where there are longer-term prepayments, for example in the case of long-term contracts with suppliers that require down payments.

Active accruals and deferrals – posting

Basically, it should be said that before the postings you have to determine which portion of the total amount should be added to which financial year. So you have to calculate how much of the total amount falls in the old financial year and how much relates to the new observation period.

The subsequent booking takes place in several steps:

  1. General booking of the business case, for example:
  • Insurance contributions to the bank, € 3,000
  1. Formation of the active accruals and deferrals:
  • Active RAP towards insurance premiums, € 1,000

Thus it has now been shown which proportion is accrued and the accrual has been established. This position is dissolved again in the following year.

  1. Dissolution of the delimitation:
  • Insurance contributions to active accruals, € 1,000

This closes the cycle of postings and the process of active delimitation is thus completely completed.

Accruals and deferrals

In the case of passive delimitation , the business case is exactly the opposite. This means that your company received an advance payment before the balance sheet date, which does not apply to the current financial year, but can be allocated to the following year. In this situation, too, delimitation ensures a more realistic depiction in the balance sheet.

An example of this is if your company sells software and the licenses are active for a year from the date of purchase. But passive demarcations are also often necessary in the offline area, let’s think of all types of memberships, for example in the fitness center.

Accruals and deferrals – posting

How is deferred income posted? Here, too, as described for active accruals and deferrals, it must first be determined which portion of the amount is allocated to the previous period and which amount is due to the new financial year.

As with active delimitation, the posting process then consists of three steps, starting with the actual posting of the business case:

  1. General booking of the business case, for example:
  • Bank of license fee received, € 500
  1. Posting to create deferred income:
  • License fee for deferred income, € 200
  1. Dissolution of the accrual in the following year
  • Passive accrual of license fee, € 200

In this case, too, the accounting cycle ends with the release of deferred income in the following year.

Dissolution of prepaid expenses

As shown in the examples, the deferred items are always released in the following year by means of a corresponding counter-entry. The dissolution ensures that the partial amount that can be allocated to the following year is actually recorded in the accounting .

It is important that, after the accruals have been created, in the following year you make sure not to write the corresponding posting for the dissolution, because apart from the fact that you otherwise have a problem in your balance sheet, the entire accrual process only starts with the posting of the dissolution really complete.

Transitional and anticipatory items

These terms come up again and again in connection with accruals, although they play a rather subordinate role.

Transitory items

In the case of transitory items, we speak of income or expenditure that was paid in advance, but which can only be allocated as expense or income after the balance sheet date . The cash flow therefore takes place before the balance sheet date. An example of this can simply be the office rent that was paid before the balance sheet date, but at the same time does not yet have an invoice date. Depending on whether it is income or expenditure, the active or passive accruals and deferrals make a corresponding allocation.

It can therefore be said that the transitory items always relate to the old year and that a distinction can be made between active RAP and passive RAP within these items.

Anticipatory items

All expenses and income of the past financial year that only lead to income or expenditure after the balance sheet date are considered to be anticipatory items. These items are then not to be resolved with accruals, but must be recorded (both in the commercial balance sheet and in the tax balance sheet) as receivables or liabilities for other assets. The prerequisite is, of course, that the incident has already resulted in a claim or liability , which will be the case in most cases

A simple example is interest income that arose in the previous year but is not paid until the following year. As the name suggests, these positions always relate to the new year, they are anticipated.

Tax balance and trade balance

With regard to prepaid expenses, it should be said that prepaid expenses are considered to be able to be accounted for in the abstract . They can of course be included in the balance sheet and are also recorded separately in the tax balance sheet, albeit separately from the category of assets.

Conclusion on accruals and deferrals

Accruals and deferrals sound more complicated at first than they ultimately are. By delimiting you ensure that amounts are allocated to the appropriate period and that your balance sheets reflect reality as precisely as possible.

Posting the accruals and deferrals takes place in a few simple steps, the process of which is always the same and therefore simple. It is important to determine in advance exactly which amount will be allocated to which period so that the postings are really correct. Don’t forget: in the following year you have to make the corresponding offsetting entry and dissolve the delimitation again!

Prepaid Expenses