What type of account is prepaid rent?
What type of account is prepaid rent? You can make an advance payment for goods or services such as rent on leased office space or insurance coverage. These prepaid expenses (prepayment) give continual benefits over time. Prepaid rent is, therefore, a type of prepaid expense; the payment of rent made before the rental period to which it is related. In this article, we will discuss what type of account prepaid rent is and how it is recorded. But first, let’s have an understanding of prepaid rent.
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Prepaid rent Explained
Prepaid rent is an account on the balance sheet that reports the amount of future rent expense that has been paid in advance of the rental period. The amount reported on the balance sheet as prepaid rent is the amount that has not yet been used up or expired as of the balance sheet date.
Assume you pay rent to a landlord of office space for the next 6 months. If the rent you paid is $600,000 which is $100,000 per month, you will record the $600,000 as prepaid rent or prepaid expense in your books. Let’s say 4 months have passed since you paid the rent, it would mean that $400,000 out of what you paid has been used up and the remaining $200,000 is still yet to expire. This means that the $400,000 will be reported as expenses on your income statement for the 4 months that have passed while the remaining $200,000 will be reported as prepaid expenses on your balance sheet.
This means that, until the amount of advance payment is actually used up in the payment for a month’s use of the leased property, it must be properly recorded on the company’s balance sheet as an asset. This prepaid rent account on the balance sheet helps to show that the company has an asset that will benefit the business in the future.
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What type of account is prepaid rent?
An asset is something that provides a current, future, or potential economic benefit for a company. It is something that the company owns or is owed to the company. Hence, an advance payment of rent is a typical example of an asset because it provides a future economic benefit to the company by reducing rent expenses when incurred. Therefore, prepaid rent is reported on the balance sheet as a current asset account that will be expensed at some point in the future.
During bookkeeping, the prepaid rent account enables the bookkeeper to track the value of the prepaid rent as an asset until the time that the prepayment amount in the account is used up. Therefore, when a company prepays for an expense, it is recognized as an asset on the balance sheet. The amount paid is entered into the prepaid expense account with a simultaneous entry to reduce the company’s cash or payment account by the same amount.
Prepaid expenses will appear on the balance sheet as a current asset except the expense is not to be incurred until after 12 months, which is usually rare. Hence, prepaid rent is recorded on the balance sheet as a prepaid expense in the current asset section as seen in the Tesla balance sheet sample below:
Source: Tesla
Journal entry for prepaid rent as an asset
Let’s look at an example of how prepaid rent is treated and recorded as an asset in accounting. Assume ABC Ltd is renting an office space and decides to make a six months advance payment to the landlord. Say ABC Ltd pays a total of $120,000 for six months. The $120,000 that the company pays is prepaid rent and the initial journal entry to record this will be as follows:
| Account | Debit | Credit |
|---|---|---|
| Prepaid rent A/c | $120,000 | |
| Cash A/c | $120,000 |
As seen in the journal entry above, prepaid rent is debited because it is an asset. According to the accounting debit and credit rules, all assets and expense accounts are debit entries. Hence, they increase with a debit entry and reduce with a credit entry.
Furthermore, as each month ends, the prepaid rent on the balance sheet is reduced by the monthly rent amount, which is $20,000 per month (i.e. $120,000/6 months). As a result, ABC Ltd would recognize a rental expense of $20,000 on the income statement. Hence, the monthly adjusting entry that would be made is as follows:
| Account | Debit | Credit |
|---|---|---|
| Rent expense A/c | $20,000 | |
| Prepaid rent A/c | $20,000 |
The bottom line is that a prepaid rent payment is recorded as an asset on the balance sheet until when the prepayment for the property has been used up. When expired, the amount that has been used up should be charged to the expense account.
Therefore, when recording prepaid rent, it is very important to not forget to shift the prepaid rent into an expense account in the exact month that the rent is consumed. If not, the financial statements would under-report the expense and over-report the asset. That is why it is advisable for the bookkeeper to keep track of the contents of the prepaid rent account and review it before closing the books at the end of each month.
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Prepaid rent as a current asset account
So, what type of account is prepaid rent? Prepaid rent is classified as a current asset account because it is the amount of rent that is paid in advance in leasing a place, which would be used up or expire in the future within one year. As a current asset, prepaid rent usually provides value to a business over several accounting periods (usually six months or a year).
Why prepaid rent is an asset account
A business will record prepaid rent as an asset on the balance sheet because it represents a future benefit that is due to the business. Then, the prepaid rent value would decrease as the benefits of the advanced rent payment are realized over time, and the amount used up would be expensed to the income statement. Hence, prepaid rent is first recorded as a current asset on the balance sheet and as it is used up, it is recorded as an expense on the income statement.
That is, as the benefits of the prepaid rent are realized, it is reported on the income statement in accordance with the Generally Accepted Accounting Principles (GAAP) matching principle. Prepaid rent is not initially recorded on the income statement because according to the GAAP matching principle, expenses cannot be reported on the income statement before they are incurred.
The GAAP matching principle requires accrual accounting in particular, which demands that expenses and revenue must be recorded in the same accounting period as incurred no matter when cash is exchanged. Hence, expenses should be reported when incurred. This is why, as prepaid rent is yet to be incurred, it is not reported on the income statement when paid but recorded on the balance sheet as a current asset.
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Prepaid rent as a permanent account
We have answered the question- ‘what type of account is prepaid rent?’, and we now know for sure that prepaid rent is a current asset account. In addition to this, prepaid rent is also considered a permanent account. It is said to be a permanent account because it is reported as an asset on the balance sheet. The accounts that are reported on the balance sheet such as assets, liabilities, and equity accounts are said to be permanent accounts. They are considered permanent accounts because they continue to maintain ongoing balances over time and are not closed at the end of the accounting period.
Since prepaid rent is found on the balance sheet as an asset, it is a permanent account. However, once the prepaid rent has been used up, the expense is recorded on the income statement as rent expense. Rent expense, on the other hand, is a temporary account. Prepaid rent is not initially recorded on an income statement in accordance with the Generally Accepted Accounting Principles (GAAP), and as such are not temporary accounts.
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