Updated July 12, 2023
Definition of Prepaid Expense
Prepaid expenses are those of the company paid in advance but will record as an expense in the income statement in future years. This expense will provide economic benefits in the coming accounting periods. The company recognizes the cost when it is realized and shows this prepaid expense as a current asset on its balance sheet.
Explanation
It represents the company’s expenses that will provide benefits in the coming accounting period but are paid in advance by the company. These expenses are initially recorded as current assets, but benefits will be realized in future years. The most common example is the insurance premium paid in the middle of the accounting period of 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 only related to that accounting period. Still, the remaining half relates to the next accounting period. Therefore, the same will be recorded in the company’s books of accounts in the accounting year it is paid.
Examples of Prepaid Expenses
Suppose Mr. Rhino started a techno-incorporation company that deals with laptops and related accessories on October 1st, 2019. For this, he has taken a factory on Rent where the rent is $500 per month. But initially, the landlord only demanded rent of 12 months on October 1st, 2019. So he paid $6,000 on that day. Also, the insurance premium of $2,000 is paid on January 1st, 2020, for the insurance of plant and machinery for one year starting from January 1st, 2020. The accounting period followed by techno incorporation is from April to March. How will it be dealt with?
Solution of Prepaid Expenses
In the above case, the Rent is paid on October 1st, 2019, for the period starting from October 1st, 2019, to September 30th, 2020. But the accounting period followed by techno incorporation will end on March 31st, 2020. So the rent paid amounting to $3,000 is for 6 months and will relate to the accounting year ending on March 2020 and, therefore, will be recorded as an expense in the same year. The remaining $3,000 is related to the next accounting period, so the same will record as prepaid insurance. In the case of the insurance premium paid, 3 months of insurance premium is the expense of the same accounting period, but the remaining premium relates to the 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.
Journal entries:
| Date | Particulars | Debit | Credit |
| 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 the income statement) | |||
| Date | Particulars | Debit | Credit |
| 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 entries in the next accounting year:
| Date | Particulars | Debit | Credit |
| 01-04-2020 | Rent A/c Dr | $ 3,000 | |
| To Prepaid Rent Expense A/c | $ 3,000 | ||
| (Entry to record prepaid expense as rent) | |||
| Date | Particulars | Debit | Credit |
| 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. Still, it is recorded as a current asset in the company’s balance sheet and, over time, the amount charged to the income statement whenever it gets realized.
Prepaid Expenses Journal Entry
The journal entry is:
| Date | Particulars | Debit | Credit |
| Prepaid Expense A/c Dr | $ | ||
| To Cash A/c | $ | ||
| (Entry to record expense which is paid in advance) | |||
Adjustment entry when the expense realize incoming accounting period is:
| Date | Particulars | Debit | Credit |
| 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 expenses 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 prepaid expenses in the accounting year when they are paid because they cannot be recorded as revenue, and such prepaid expense is the company’s current asset. 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 will be debited.
Prepaid Expenses vs Accrued Expenses
The difference between prepaid expenses and accrued expenses is as follows:
- Prepaid expenses represent expenses that a company pays in advance, with the services to be received in the future. Accrued expenses involve services already received, but the payment is still pending.
- The company reports prepaid expenses as current assets on its balance sheet, while it reports accrued expenses as a current liability on its balance sheet.
Advantages of Prepaid Expenses
The advantages of prepaid expenses are as follows:
- The prepaid expenses help in income tax deductions. To take advantage of some income tax policies, businesses prepay their expenses to get additional deductions.
- Also, by paying expenses in advance, the business can save them from inflating cost, 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 will be received in future years. These expenses are the company’s current assets and are reported in the company’s balance sheet at the end of the accounting period.
Recommended Articles
This is a guide to Prepaid Expenses. Here we also discuss the definition and prepaid expenses journal entry, examples, and advantages. You may also have a look at the following articles to learn more –
