Booking expenses to prepaid, that are not really paid yet.

Hello, I have a situation where a company's active process for vendor invoices that are for more than one period, are booked to AP and directly to Prepaid Expense asset account. Then the adjustment is made for the first period to expense. The remainder balance of the invoice stays in prepaid. That would be fine and great, BUT, the invoice is not truly paid at the end of the period (or multiple periods). How do you treat an invoice for say, a year long subscription or contract, that you need to allocate the expense each month but you are not truly paying the invoice for months ahead of time? It just does not seem like it belongs in prepaid at all if it is not truly paid.

If the invoice represents a legal contractual obligation then it is appropriate to record the liability in A/P or some other liability account. The debit would go to some asset account like a prepaid expense that represents the value obtained from the contract.

DR prepaid exp 1200
CR account payable 1200
To record the annual contract

DR account payable 100
CR cash 100
To pay part of the bill each month

DR expense 100
CR prepaid expense 100
To record the monthly expense each month

Alternatively:

DR expense 100
CR cash 100
To pay a portion of the bill each month

Thanks Frankly,

But to place the balance of an unpaid amount into an asset account that is named 'pre-paid' feels wrong. It is not paid. Would it better be classified as "future value of contractual obligations" asset account? Rather than Pre-paid? Pre-paid accounts (in my opinion) represent cash payments for future services and if they are truly unpaid at the end of the period is your balance sheet misleading? Also, when doing an accrual to cash conversion for tax purposes, the pre-paid account comes into play, wouldn't it skew the conversion?

An example - a 1 year software contract due up front for say $12,000, due on April 1 for April 1-March31. Invoice for the full amount is received, but not paid until say, August 31 (cash flow or other reasons) Would you account for the entire $12,000 as a liability April 1 or as you consume the monthly portion of the contract? Would the circumstances be different if you receive an invoice for a year long subscription to a service that you decide not to pay (again, maybe cash flow issues) for a few months?

Thanks for the advice!

I agree that it is not a pre-paid expense if it is not actually pre-paid. I thought pre-paid exp asset account would only be used for a cash-basis taxpayer who paid, but can't deduct, the expense in the current period. If it's an accrual taxpayer, why use a pre-paid expense asset at all? If it's a cash taxpayer who knows they aren't going to pay the bill now, why not record a future-dated bill?

Seems that if the bill is for a year-long contract/subscription, then under the 12 month rule, you could debit the expense account (ie subscriptions) and credit accounts payable. Don't know why this would have to hit the prepaid account at all. However, if the prepaid account is the way it's been being done, to switch now would probably be considered a change of accounting method. (Of course, if the subscription was for 3 years, you would follow the general rule, and only deduct the portion allocable to the current year.)

If you are obligate to pay and have not paid, then you have a liability that should be recorded. It would show up on the balance sheet. The other half of that must be recorded as well. Whether the label on the account is "prepaid expense" or "future value of contractual obligations" would not seem to make much difference; either would show up on the asset portion of the balance sheet.

I think what I would do would be to ignore the $12,000 invoice and simply pay them $1,000 every month, charging the payment to expense.

If you are obligate to pay and have not paid, then you have a liability that should be recorded. It would show up on the balance sheet. The other half of that must be recorded as well. Whether the label on the account is "prepaid expense" or "future value of contractual obligations" would not seem to make much difference; either would show up on the asset portion of the balance sheet.

I still don't understand why it wouldn't show up as expense, for accrual basis (and nothing, for cash basis, where this is no A/P). Why would it show up as an asset, when there is actually no asset? (which was the original question, as I understand it)

I still don't understand why it wouldn't show up as expense, for accrual basis (and nothing, for cash basis, where this is no A/P). Why would it show up as an asset, when there is actually no asset? (which was the original question, as I understand it)

One does not become liable to pay somebody without getting something in return. Whatever they got that created the liability is the asset. The asset is expensed when used (accrual) or paid (cash).

If you are obligate to pay and have not paid, then you have a liability that should be recorded. It would show up on the balance sheet. The other half of that must be recorded as well. Whether the label on the account is "prepaid expense" or "future value of contractual obligations" would not seem to make much difference; either would show up on the asset portion of the balance sheet.

I think what I would do would be to ignore the $12,000 invoice and simply pay them $1,000 every month, charging the payment to expense.

To play devils advocate, when you say it would not make much difference whether its booked to prepaid or future value of contractual obligations on the asset side of a balance sheet... Cash is an asset, but you certainly wouldn't book it there. It appears listing it as a pre-paid asset, implies you have actually paid for it. All assets are not created equal.

Is there any guidance on not booking the entire invoice? This company records on full accrual basis for financial reporting purposes but is a cash basis taxpayer, so the prepaid account is used to compute the accrual to cash conversion for tax purposes. Taking the example of $12000 placed in prepaids when not truly paid, would understate your accrual to cash conversion- cash basis income

To play devils advocate, when you say it would not make much difference whether its booked to prepaid or future value of contractual obligations on the asset side of a balance sheet... Cash is an asset, but you certainly wouldn't book it there. It appears listing it as a pre-paid asset, implies you have actually paid for it. All assets are not created equal.

If you buy a machine on credit the liability is booked. The machine still gets recorded as an asset even though it has not been paid for.

If you book a $12,000 liability, where would be the proper place on the balance sheet to record the rest of the transaction?

Frankly, I get that the other side of the liability is an asset or expense, I am not disputing that, but the type of asset is my question. I can't get on board with it being considered a pre-paid if it isn't. The bigger question is, if your financial statements are prepared under GAAP, where is it supposed to go on the asset side of the equation? Pre-paid feels wrong, 'other current assets - (insert name here)" I can see. Also, what are the GAAP guidelines for not booking the whole $12000 when the invoice is received, as you stated you would ignore it and just book and pay the expense each month. I assume the terms of the invoice would prevail? What would determine per GAAP if you book the entire invoice vs ignoring it and paying monthly, in this case.

What does the seller post in his books? DR receivables, CR --- ?

Should anything be booked at all? If there is a contract that says "You provide a future service, and I'll pay for the service". What gets booked based on that agreement? Does the mere fact that one party mailed an invoice to the other party necessitate a journal entry? Has there been any performance on the contract?

I agree with Frankly's logic. If the seller doesn't book anything, then the buyer shouldn't either.

See similar discussion:Accounts Payable - Prepaid Expenses

If GAAP, would this issue fall under ASC 440?

If it's immaterial and makes you feel better, drop it in 'other assets' for GAAP financials.

Here is your definition of prepaid insurance: Carrying amount as of the balance sheet date of unamortized costs of insurance coverage, which will be charged against earnings ratably over the period in which contractually agreed upon coverage's will be in effect; such periods expire within one year or the normal operating cycle, if longer.

In contrast, definition of prepaid advertising: Carrying amount as of the balance sheet date of amounts paid in advance for advertising airtime or print media advertising space for which the advertising associated with the payment will air or appear in print within one year or the normal operating cycle, if longer. Also includes direct-response advertising reported as assets.