Examples of Prepaid Expenses
Prepaid expenses are those of the company that are 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 expense is always recognized when realized, and this prepaid expense is shown under the head’s current asset in the company’s balance sheet.
Explanation
The company pays prepaid expenses in advance, providing benefits in the coming accounting period. These expenses initially record as current assets, but the company will realize the benefits in future years. The insurance premium paid in the middle of the 12-month accounting period is the most common example of a prepaid expense. The company will book half of the insurance premium paid as an expense in the same accounting year they pay because it is only related to that accounting period. Still, the remaining half relates to the next accounting period. Therefore, the same will record as prepaid expenses in the company’s books of accounts in the accounting year in which it is paid.
Examples
Suppose Mr. Rhino started 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 only demanded rent of 12 months on 1st October 2019. So he paid $6,000 on that day. Also, the insurance premium of $2,000 is paid on 1st January 2020 for the plant and machinery insurance for one year starting from 1st January 2020. So the accounting period followed by techno incorporation is April to March. How will the prepaid expenses be dealt with?
Solution: 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 for 6 months 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. Regarding the insurance premium paid, 3 months’ insurance premium is the expense of the same accounting period. Still, 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 as a prepaid expense.
Journal entries:
| Date | Particulars | Debit | Credit |
| 1/10/2019 | 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 |
| 1/1/2020 | 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 |
| 1/4/2020 | 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 |
| 1/4/2020 | 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 prepaid expense account initially seems to be an expense, but it is recorded as a current asset in the company’s balance sheet. Over time, the amount is charged to the income statement whenever it gets realized.
Prepaid Expenses Journal Entry
The journal entry for the prepaid expense 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 is realized in the coming 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
The prepaid expenses are recognized because they 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. 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 other current assets (cash/bank) decrease (credited). Then in the accounting year, when an 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 expenses and accrued expenses is as follows:
- The prepaid expenses are the expenses paid in advance, but the services will receive in the future; 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 company’s balance sheet, whereas accrued expenses are reported as a current liability in the company’s balance sheet.
Advantages
The advantages are as follows:
- First, the prepaid expenses help in income tax deductions. Second, businesses pay for additional deductions to benefit from some income tax policies.
- Also, by paying expenses in advance, the business can save them from inflating cost, thereby saving the business money.
Conclusion
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.
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