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A prepaid expense is an expenditure paid for in one accounting period, but for which the underlying asset will not be consumed until a future period. When the asset is eventually consumed, it is charged to expense. If consumed over multiple periods, there may be a series of corresponding charges to expense. Expenditures are recorded as prepaid expenses in order to more closely match their recognition as expenses with the periods in which they are actually consumed. If a business were to not use the prepaids concept, their assets would be somewhat understated in the short term, as would their profits. The prepaids concept is not used under the cash basis of accounting, which is commonly used by smaller organizations. Examples of Prepaid ExpensesAn example of a prepaid expense is insurance, which is frequently paid in advance for multiple future periods; an entity initially records this expenditure as a prepaid expense (an asset), and then charges it to expense over the usage period. Another item commonly found in the prepaid expenses account is prepaid rent.
A prepaid expense is carried on the balance sheet of an organization as a current asset until it is consumed. The reason for the current asset designation is that most prepaid assets are consumed within a few months of their initial recordation. If a prepaid expense were likely to not be consumed within the next year, it would instead be classified on the balance sheet as a long-term asset (a rarity). Prepayment AccountingThe basic accounting for a prepaid expense follows these steps:
A best practice is to not record smaller expenditures into the prepaid expenses account, since it takes too much effort to track them over time. Instead, charge these smaller amounts to expense as incurred. To extend this concept further, consider charging remaining balances to expense once they have been amortized down to a certain minimum level. Both of these actions should be governed by a formal accounting policy that states the threshold at which prepaid expenses are to be charged to expense. Example of Prepaid Expenses AccountingA company pays $60,000 in advance for directors and officers liability insurance for the upcoming year. The journal entry is:
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Common Reasons for Prepaid ExpensesThe two most common uses of prepaid expenses are rent and insurance. 1. Prepaid rent is rent paid in advance of the rental period. The journal entries for prepaid rent are as follows: Initial journal entry for prepaid rent:
2. Prepaid insurance is insurance paid in advance and that has not yet expired on the date of the balance sheet. Initial journal entry for prepaid insurance: Adjusting journal entry as the prepaid insurance expires: Prepaid Expenses ExampleWe will look at two examples of prepaid expenses: Example #1Company A signs a one-year lease on a warehouse for $10,000 a month. The landlord requires that Company A pays the annual amount ($120,000) upfront at the beginning of the year. The initial journal entry for Company A would be as follows: At the end of one month, Company A would’ve used up one month of its lease agreement. Therefore, prepaid rent must be adjusted: Note: One month corresponds to $10,000 ($120,000 x 1/12) in rent. The adjusting journal entry is done each month, and at the end of the year, when the lease agreement has no future economic benefits, the prepaid rent balance would be 0. Example #2Upon signing the one-year lease agreement for the warehouse, the company also purchases insurance for the warehouse. The company pays $24,000 in cash upfront for a 12-month insurance policy for the warehouse. The initial journal entry for Company A would be as follows: At the end of one month, Company A would have used up one month of its insurance policy. Therefore, prepaid insurance must be adjusted: Note: One month corresponds to $2,000 ($24,000 x 1/12) in insurance policy. The adjusting journal entry is done each month, and at the end of the year, when the insurance policy has no future economic benefits, the prepaid insurance balance would be 0. Effect of Prepaid Expenses on Financial StatementsThe initial journal entry for a prepaid expense does not affect a company’s financial statements. For example, refer to the first example of prepaid rent. The initial journal entry for prepaid rent is a debit to prepaid rent and a credit to cash. These are both asset accounts and do not increase or decrease a company’s balance sheet. Recall that prepaid expenses are considered an asset because they provide future economic benefits to the company. The adjusting journal entry for a prepaid expense, however, does affect both a company’s income statement and balance sheet. Refer to the first example of prepaid rent. The adjusting entry on January 31 would result in an expense of $10,000 (rent expense) and a decrease in assets of $10,000 (prepaid rent). The expense would show up on the income statement while the decrease in prepaid rent of $10,000 would reduce the assets on the balance sheet by $10,000. More ResourcesThank you for reading CFI’s guide to Prepaid Expenses. To keep learning and advancing your career, the following CFI resources will be helpful:
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