A prepaid expense is a type of asset on the balance sheet that results from a business making advanced payments for goods or services to be received in the future. Prepaid expenses are initially recorded as assets, but their value is expensed over time onto the income statement. Unlike conventional expenses, the business will receive something of value from the prepaid expense over the course of several accounting periods.
What is a prepaid account?
A prepaid account tracks expenses that will be made in the future. Example: You have a $1000 monthly premium for insurance. At the beginning of the year you credit Cash $1,200 and debit Prepaid Insurance $1,200. If you don’t end up using it, it can be rolled over into a prepaid account the next year.
Prepaid insurance is considered a business asset, and is listed as an asset account on the left side of the balance sheet. Prepaid insurance is usually considered a current asset, as it will be converted to cash or used within a fairly short time.
What is considered a prepaid expense?
When the check for the deposit is cut and sent to the vendor, the business records the transaction on the balance sheet by debiting prepaid inventory and crediting cash. This will increase the value of assets and lower the amount of available cash. If the deposit will be used as a long-term security deposit, nothing else needs to be done until that money is applied against a final invoice or is returned to the business. This will create the expense for the balance of the invoice. The balance of the invoice should be paid the same way that bills are typically paid.
This reflects the depletion of the asset by the amount of one month’s insurance, and it correctly enters the expense on the income statement. Most corporate insurance policy premiums are paid in full for the year before the policy year begins.
A prepaid expense is carried on the balance sheet of an organization as a current asset until it is consumed. The reason why is because most prepaid assets are consumed within a few months of being recorded. If a prepaid expense were likely to not be consumed within the next year, it would instead be along-term asset(this is not common). The payment of the insurance expense is similar to money in the bank, and as the money is used up, it is withdrawn from the account in each month or accounting period.
If the money is returned to the company, credit prepaid inventory and debit the cash account, reversing the original entry. Prepaid expenses refers to payments made in advance and part of the amount will become an expense in a future accounting period. A common example is paying a 6-month insurance premium in December that provides coverage from December 1 through May 31. On November 20, the payment is entered with a debit of $2,400 to Prepaid Insurance and a credit of $2,400 to Cash.
In the twelfth month, the final $10,000 will be fully expensed and the prepaid account will be zero. According to generally accepted accounting principles (GAAP), expenses should be recorded in the same accounting period as the benefit generated from the related asset. For example, if a large Xerox machine is leased by a company for a period of twelve months, the company benefits from its use over the full time period.
- A prepaid expense is carried on the balance sheet of an organization as a current asset until it is consumed.
- Prepaid insurance is considered a business asset, and is listed as an asset account on the left side of the balance sheet.
Prepaid expenses journal entry
Recording an advanced payment made for the lease as an expense in the first month would not adequately match expenses with revenues generated from its use. Therefore, it should be recorded as a prepaid expense and allocated out to expense over the full twelve months.
You would then make this same adjusting journal entry at the end of each month until the policy expires. Certain expenses, such as taxes and insurance, are paid in lump sums during one particular accounting period. The benefits from these payments extend past the single accounting period, so it is not accurate to charge the full payment to an expense account at that time. These types of payments are handled using a prepaid expense account.
Prepaid insurance premiums are classified as a current asset, because their benefit will be realized in full within the next 12 months. When you pay the insurance premium, post the prepaid expense as a debit to a prepaid insurance account and then credit the cash account. As time passes, you decrease the prepaid insurance account and record insurance expense. For example, let’s say your company pays $2,400 for a 1-year insurance policy upfront.
If the premium were $1,200 per year, for instance, you would record the check for $1,200 as a credit to the cash account in your journal, decreasing the value of that account. Then you would enter a debit of $1,200 to the prepaid insurance asset account, increasing its value. For example, assume ABC Company purchases insurance for the upcoming twelve month period. ABC Company will initially book the full $120,000 as a debit to prepaid insurance, an asset on the balance sheet, and a credit to cash.
How to record a prepaid expense: Examples
Businesses make advance payments for a variety of different expenses. Any expense that is paid in advance of actually receiving the benefit of the payment is considered a prepaid expense for accounting purposes. Prepaid expenses are recorded on a company’s balance sheet as a current asset, and then recognized as an expense when it is incurred. There are many categories of prepaid expenses including legal fees, insurance premiums and estimated taxes.
Each month, you will need to move the used portion of the insurance payment to an expense account. At the end of the month, before the books are closed for the month, make one double entry to the journal. If the premium were $1,200 per year, you would enter a credit of $100 to the prepaid insurance asset account, decreasing its value. Then you would enter a debit to the insurance expense account, increasing the value of the expenses.
The asset column on a balance sheet represents items the company owns. Prepaid expenses are also considered assets and may include prepaid insurance, rent security deposits and prepaid inventory — a deposit made on inventory not yet received. Any business contract agreements that require a deposit or payment in advance are prepaid expenses. Debit the related prepaid account for the amount of the advanced payment, and credit the cash account for an equal amount.
You would initially debit the Prepaid Insurance account for $2,400 and credit the Cash account for $2,400. After one month, you will have used up one month of your insurance policy and only have 11 months remaining on the policy. Thus, you record an adjusting journal entry at the end of the first month by debit Insurance Expense for $200 and crediting the Prepaid Insurance account for $200.