Definition of Prepaid Expense
Prepaid expenses are those expenses of the company which are paid in advance but will be recorded as an expense in the income statement in the future years as this expense will provide economic benefits in coming accounting periods and the expense is always recognized when it is realized and this prepaid expense is shown under the head current asset in the balance sheet of the company.
It represents those expenses of the company that will provide benefit in the coming accounting period but are paid in advance by the company. These expenses are initially recorded as current assets but benefits of the same will be realized in future years. The most common example is the insurance premium which is paid in the middle of the accounting period for 12 months. Half of the insurance premium paid, will be booked as an expense in the same accounting year in which it is paid because it is related to that accounting period only but the remaining half relates to the next accounting period. Therefore, the same will be recorded in the books of accounts of the company in the accounting year in which it is paid.
Examples of Prepaid Expenses
Suppose Mr. Rhino started a company named techno incorporation which deals with laptops and related accessories on 1st October 2019. For this, he has taken a factory on Rent where the rent is $500 per month. But initially, the landlord demanded rent of 12 months on 1st October 2019 only. So he paid $6,000 on that day. Also, the insurance premium of $2,000 is paid on 1st January 2020 for the insurance of plant and machinery for one year starting from 1st January 2020. The accounting period followed by techno incorporation is April to march. How it will be dealt with?
Solution of Prepaid Expenses
In the above case, the Rent is paid on October 1st, 2019 for the period starting from 1st October 2019 to 30th September 2020. But the accounting period followed by techno incorporation will end on 31st March 2020. So the rent paid amounting to $3,000 is for 6 months that will relate to the accounting year ending on March 2020 and therefore will be recorded as an expense in the same year and the remaining $3,000 is related to the next accounting period so the same will be recorded as prepaid insurance and in case of the insurance premium paid, 3 months insurance premium is the expense of same accounting period but the remaining premium relates to next accounting year. Therefore, $500($2000/12*3) is booked as an expense in the same accounting year, and the remaining $1,500 ($2,000-$500) will be recorded.
|01-10-2019||Prepaid Rent Expense A/c Dr||$ 3,000|
|Rent A/c Dr||$ 3,000|
|To Cash/Bank A/c||$ 6,000|
|(Entry to record prepaid expense and expense in income statement)|
|01-01-2020||Prepaid Insurance Expense A/c Dr||$ 1,500|
|Insurance Premium A/c Dr||$ 500|
|To Cash/Bank A/c||$ 2,000|
|(Entry to record prepaid expense and expense in the income statement)|
Adjusting entry in the next accounting year:
|01-04-2020||Rent A/c Dr||$ 3,000|
|To Prepaid Rent Expense A/c||$ 3,000|
|(Entry to record prepaid expense as rent)|
|01-04-2020||Insurance premium A/c Dr||$ 1,500|
|To Prepaid Insurance Expense A/c||$ 1,500|
|(Entry to record prepaid expense as Insurance expense)|
What Kind of Account Are Prepaid Expenses?
The account at first seems to be an expense but actually, it is recorded as a current asset in the balance sheet of the company and over time the amount is charged to the income statement whenever it gets realized.
Prepaid Expenses Journal Entry
The journal entry is:
|Prepaid Expense A/c Dr||$|
|To Cash A/c||$|
|(Entry to record expense which is paid in advance)|
Adjustment entry when the expense is realized incoming accounting period is:
|Expense A/c Dr||$|
|To Prepaid Expense A/c||$|
|(Entry to record prepaid expense as expense in the next accounting year)|
Reasons for Prepaid Expenses
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 expense in that accounting period in which it is paid but not yet become due.
Impact of Prepaid Expenses
The prepaid expenses are first recorded as a prepaid expense in the accounting year when they are paid because they cannot be recorded as revenue and such prepaid expense is the current asset of the company. So basically in the accounting year when they are paid one current asset (prepaid expense) increases (debited) and another current asset (cash/bank) decreases (credited). Then in the accounting year when the expense is utilized the prepaid expense account will be credited and the actual account to which such expense relates is debited.
Prepaid Expenses vs Accrued Expenses
The difference between prepaid expense and accrued expense is as follows:
- The prepaid expenses are the expenses that are paid in advance but the services will be received in the future but in the case of accrued expenses the services are already received but the payment is still to be done.
- Prepaid expenses are reported as current assets in the balance sheet of the company whereas accrued expenses are reported as a current liability in the balance sheet of the company.
Advantages of Prepaid Expense
The advantages of prepaid expenses are as follows:
- The prepaid expenses help in income tax deductions. For taking the advantage of some income tax policies businesses prepay their expenses for getting additional deductions.
- Also by paying expenses in advance, the business can save them from the inflating cost of the expense thereby saving the business money.
Conclusion – Prepaid Expenses
Thus, prepaid expenses are the expenses of the business that are paid in advance but the benefit of the same will be received in future years. These expenses are the current assets of the company and are reported in the balance sheet of the company at the end of the accounting period.
This is a guide to Prepaid Expense. Here we also discuss the definition and prepaid expenses journal entry along with examples and advantages. You may also have a look at the following articles to learn more –