What is Prepaid Rent?

Prepaid Rent and Accounting

Accounting for your prepaid rent expenses doesn’t need to be complicated, but it is something that requires your attention at the end of the month. The accountant or bookkeeper records the prepaid asset to the balance sheet account with a basic general ledger system. This could mean having to adjust the entry to reclass the rent expense to a prepaid account. From there, accountants include a monthly entry to reduce the prepaid expense account and record the rent expense.

While some accounting systems automate the amortization of a prepaid rent payment, you should always check the account at least once per accounting period. Automation is a great idea, but it isn’t perfect. Some things still require a human touch, including prepaid rent on balance sheet entries.

Prepaid Rent: Asset or Liability?

What type of account is prepaid rent? Is it an asset or liability? It depends on which side of the equation your company is on. Prepaid rent payments are classed as an asset when the organization makes a prepaid rent payment to a landlord or other third party. The payment becomes a liability when a company is given prepayment from tenants or third parties.

It’s vital that business owners, accountants, and managers understand the distinction between prepaid rent as an asset or liability. Failing to classify prepayments on a balance sheet causes all manner of problems. It causes misleading financial information that affects your ability to make informed business decisions.

Prepaid Rent vs Rent Expense

The key difference between prepaid rent and rent expenses is that prepaid rent is a balance sheet account while rent expenses go on the income statement. Prepaid rent generally covers multiple rent payments at once, while a rent expense only covers a single payment. The prepaid account will always be listed as an asset or liability on a balance sheet.

When the payments go through, and the prepayment is reduced, the expense is recorded on the income statement. While prepaid rent and rent expenses are related, they remain significantly different and are recorded differently.

Example of Prepaid Rent Accounting

Company A pays six months of rent in advance. The cash on the balance sheet is credit and reduced accordingly. The prepaid rent asset account gets debited for the same amount of money. One rent payment goes from the prepaid rent asset account to the rent expense account as the months pass. The process is repeated as many times as necessary across the accounting period.

Prepaid Rent Journal Entry Example

As mentioned before, a company makes a prepaid rent journal entry by debiting a prepaid rent account and crediting a cash account after making the advanced payment. Here’s how it looks:

This example journal entry doesn’t involve the income statement account because both the prepaid rent and cash amount go on the balance sheet. Therefore, this journal entry covers increasing one asset (the prepaid rent) and decreasing another asset (the cash account).

The company makes a journal entry debiting the rent expense account and crediting prepaid rent to account for the monthly rent payments. The journal entry shows an adjust prepaid rent balance after the rental payment is taken out, as follows:

If a company fails to account for rent expenses by reducing the prepaid rent, as shown above, the total assets get overstated while the total expenses are understated. It appears as if the company has more money than it really does and has spent less than it really has.

Suppose that Company A makes a prepaid rent payment of $5,000 on December 28, 2020. The money covers two months of rent in January and February 2021. In this case, the company should put the prepaid rent entry into the books on December 28 by recording an advance payment as shown below:

There would be no changes to the total assets because while the prepaid rent asset account increases by $5,000, the cash amount asset is decreased by $5,000.

The company makes a new journal entry on January 31, 2021. This entry recognizes the rent expense for the month and shows how the money left the prepaid rent account:

The journal entry shows how the balance for the prepaid rent went down by $2,500 because the benefit of this expenditure was used up in January. If the company fails to make an adjusting entry like the one shown above, it will overstate assets and understate expenses by $2,500. Therefore, companies must make the adjusting entry by increasing the expense account and decreasing the asset account.

Later, on February 31, the company makes one more adjusting entry to show the rent payment coming out of the prepaid rent account:

After this entry, the prepaid rent balance becomes zero while the rent expense account increases to $5,000, creating a balance between the two accounts.

Prepaid Rent on The Balance Sheet

Prepaid rent is either an asset or a liability on the balance sheet. Either way, it is typically considered a current asset or liability rather than a long-term one. When reviewing prepaid rent normal balance, it’s important you substantiate the balance with supporting documents. Those documents include bank statements or bills. They help assure the balance is accurate across the books.

Preparing Prepaid Rent Journal Entry

Preparing for a prepaid rent journal entry starts with knowing when to make one. You should always create a personal expenses journal entry when you make the purchase, regardless of when you actually use the goods or services. For prepaid rent, that means making an entry after paying the advance rent.

Before jumping headfirst into making journal entries, it helps to know how each main account is affected by the credits and debits of your business. Assets and expenses are both increased by debits or decreased by credits. Liabilities, equities, and revenue are all increased by credit and decreased by debit.

To prepare and make your journal entry for prepaid rent, you should start by debiting the prepaid expenses account. This is an asset account, meaning it is increased by debit. Each debit must have an equal credit to balance the accounting equation. Enter the amount for the account used to make the payment, such as your cash or crediting account.

Make sure you have all the relevant documents, such as invoices and receipts, to prepare and enter the prepaid rent into your balance sheet accordingly.

Final Thoughts

Prepaid rent is rent paid in advance. Companies record the overall amount at first and then remove individual payments month by month. Which type of account prepaid rent depends on whether your company pays prepaid rent or accepts it from someone else.

Accounting for prepaid rent is easier than it looks. So long as you credit and debit the right accounts by the right amounts, you shouldn’t run into any problems. Remember, incorrect accounting makes you think you have more money than you do and leads to bad financial decision-making. Provide source documents and evidence of your accounts where possible for the most accurate accounting.