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Understanding prepaids and accounts payable

Let’s be honest, accounting can sometimes be a challenge. But what makes it difficult? Not understanding the fundamentals of how accounts work, without understanding the relationships and purpose of each account, nothing will make sense! So, today, Henry+Horne is here to help you understand the difference between prepaids and accounts payable.

First, let’s make it clear: prepaid expenses are an asset, and accounts payable is a liability.

Why is Prepaid Expense an Asset? What is a Prepaid?

A prepaid is when you pay for a good or service in advance, so it represents an expenditure that has future benefit, and assets are things with future benefit. Therefore, prepaids are classified as an asset.

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It is also important to note that prepaids are recorded during the accounting period when the transaction has incurred and expensed throughout later periods as the benefits are realized (consumption method). GASB allows users to record prepaids on the purchase method for governmental funds, but that fact must be disclosed in the summary of significant accounting policies of the financial statements. Most governments will use the consumption method in the governmental fund statements, unless those transactions are immaterial to the statements. The following is an example of the consumption method for prepaids.

Example of Prepaid

An example often used for prepaids is rent:

ABC Government signs a one-year lease on a building for $15,000 a month. The landlord requires ABC Government to pay the full annual amount of $180,000 at the beginning of the year.

How would ABC Government record this transaction?

Debit: Prepaid Rent        $180,000

Credit: Cash                     $180,000

Remember that while ABC Government paid for rent at the beginning of the year, they have not received the full service, which means rent is an asset with future benefit because the landlord owes ABC Government the space for the remainder of the one year contract.

After one month, how would ABC Government reverse this entry?

Debit: Rent Expense        $15,000

Credit: Prepaid Rent        $15,000

The entry must be reversed after the benefit is realized. In this case, ABC Government received their rental space for a month, so they need to realize that benefit in order to keep track of how much future rent benefit they have left. In this case, after a month of residing in the building, ABC Government should expect $165,000 of prepaid rent to be used up on later periods. This reversing journal entry will continue every month, until the lease ends.

 What is Accounts Payable?

An account payable represents a Government’s obligation to pay off a short-term debt to its creditors or suppliers. In other words, these are short-term items your organization owes money on.

Example of Accounts Payable

XYZ Government purchases equipment on credit for $150,000.

Debit: Equipment                      $150,000

Credit: Accounts Payable        $150,000

XYZ Government must record this entry to reflect that they have a liability for this $150,000 equipment.

How should XYZ Government reverse the entry once they pay off their debts?

Debit: Accounts Payable        $150,000

Credit: Cash                             $150,000

Once XYZ Government pays their debt for the equipment, they must record the decrease in their liabilities and cash.

Final Note

Accounts payable is a liability, which represents things you owe. Prepaids are assets that have been paid for beforehand and still have future benefit in later accounting periods.  Therefore, when an auditor discovers a journal entry that debits a prepaid and credits an A/P it raises a red flag for the auditor to investigate it further for error. Make sure to review your entries for mistakes, such as this, in order to prevent or detect those types of misstatements.

Contact a Henry+Horne professional with any qustions.

Anh Dao