Prepaid Expenses

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  • If the prepayment covers a longer period, then classify the portion of the prepaid insurance that will not be charged to expense within one year as a long-term asset.
  • Hence, it can be recorded by using the asset method and expense method of accounting.
  • As these accounts are both asset accounts, they do not increase or decrease any value on the balance sheet.
  • It is important to note that the process of recording any prepaid expense only takes place in accrual accounting.
  • Then, in each successive month for the next twelve months, there would be adjusting entries of prepaid insurance that debit the insurance expense account and credit the prepaid insurance account by $100.

If so, these types of purchases require special attention in your books. Prepaid expenses usually provide value to a company over an extended period law firm bookkeeping of time, such as insurance or prepaid rent. Many types of business insurance are paid as a lump sum in advance of a specific coverage period.

Prepaid Expenses: Definition, Journal Entry, and Examples

They are recognized because the expenses are booked in the books of accounts when they become due regardless of actual cash payment (matching principle). So prepaid expense account is created to record the payment of expenses in that accounting period in which it is paid but not yet become due. The insurance expense account increases by the debit entry while the prepaid insurance account decreases by the credit entry.

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For instance, if a business pays $12,000 in rent for a 12-month lease on January 1st, the monthly prepaid rent expense would be $1,000. Prepaid expenses are considered assets for a business because they represent future economic benefits. When a business pays for goods or services in advance, it expects to receive the benefits of those goods or services over a period of time. For example, if a business pays for a year’s worth of insurance premiums upfront, it expects to receive the benefits of that insurance coverage over the course of the year. The initial journal entry for a prepaid expense does not affect a company’s financial statements. The initial journal entry for prepaid rent is a debit to prepaid rent and a credit to cash.

What are the Uses of Prepaid Expenses?

Consider the previous example from the point of view of the customer who pays $1,800 for six months of insurance coverage. Initially, she records the transaction by increasing one asset account (prepaid insurance) with a debit and by decreasing another asset account (cash) with a credit. After one month, she makes an adjusting entry to increase (debit) insurance expense for $300 and to decrease (credit) prepaid insurance for $300.

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In other words, prepaid expenses are expenditures paid in one accounting period, but will not be recognized until a later accounting period. Prepaid expenses are initially recorded as assets, because they have future economic benefits, and are expensed at the time when the benefits are realized (the matching principle). Sticking with the accrual method of accounting, a second important consideration when recording a prepaid asset is the utilization period. If the entirety of the prepaid asset is to be consumed within 12 months, then it is deemed a current asset. However, it is not uncommon to see contracts spanning multiple years, being paid in advance. In these scenarios the portion of the prepaid obligation which exceeds 12 months is recognized as a long-term or noncurrent asset.

Is Prepaid Expense an Asset?

Companies must accurately handle prepaid expenses by debiting the appropriate prepaid account and crediting the cash account. Failing to record prepaid expenses accurately can result in inaccurate financial reports and misrepresentations of the company’s financial position. Prepaid expenses refer to expenses that a business pays in advance before they are actually incurred. In accounting, you might want to record a prepaid expense as a prepaid asset on the balance sheet until it’s used or consumed. Under the accrual method, no expense is recorded until it is incurred. In layman’s terms, prepaid expense is recognized on the income statement once the value of the good or service is realized, i.e, the service or good is delivered.

For example, if you believe fuel prices will go up next month, you may want to prepay for fuel to avoid paying extra when the price rises. You may want to set up an amortization table to track the decrease in the account over the policy term and to determine what the journal entries will be. As each month passes, adjust the accounts by the amount of rent you use. Since the prepayment is for six months, divide the total cost by six ($9,000 / 6).