What Are Prepaid Expenses?

The prepaid expenses asset account works in much the same way as the change in inventory and accounts receivable accounts. However, changes in prepaid expenses are usually much more minor than changes in those other two asset accounts.

The company charges the beginning balance of prepaid expenses to expense accounts in the current year. Still, You paid out the cash last year. In this period, the business pays cash for the next period’s prepaid expenses, which affects this period’s cash flow. Still, it doesn’t affect net income until the next period. Simple, right?

As a business grows, it needs to increase its prepaid expenses for fire insurance premiums, which you pay in advance of the insurance coverage, and its stocks of office supplies. Increases in accounts receivable, inventory, and prepaid expenses are the cash flow price a business has to pay for growth. Rarely do you find a company that can increase its sales revenue without increasing these assets.

The lagging behind effect of cash flow is the price of business growth. Managers and investors need to understand that increasing sales without increasing accounts receivable isn’t a realistic scenario for growth. In the real business world, you generally can’t enjoy growth in revenue without incurring additional expenses.