written by | May 31, 2022

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What Are Prepaid Expenses Journal Entry? Explained With Examples

Any charges that a corporation expects to incur in the future are prepaid expenses. They pay for them in advance. Prepaid expenses are prevalent because there are numerous instances where payment is required before goods or services are delivered.

Some businesses require payment before shipping, which is documented in the accounting records as a prepaid expense. Rent, utilities, and insurance are all examples of prepaid expenses.

Prepaid expenses are crucial for running a business and must be understood to manage cash flow. This article will explain when prepaid expenses can be incurred and how to include prepaid charges in your diary.

Did You Know?

You can deduct prepaid insurance premiums when you pay it and don’t apply for the extending period of over 12-month after the taxable year had ended when you made the payment.

What Are Prepaid Expenses Journal Entry?

Prepaid expenses are when you pay in advance for an expense you will use over multiple accounting periods. Prepaid expenses are created when the expense is paid, and the actual revenue doesn't take place at once. 

Want to know about the prepaid expense? Learn everything by referring to the following section

What Is Considered a Prepaid Expense?

Both individuals and businesses can accrue prepaid expenses. Several purchases that you make in small businesses can be considered prepaid expenses.

Here are some common prepaid expenses examples :

  • Policies for small businesses in insurance
  • Cost of renting commercial space
  • Equipment that you have to pay before it is used
  • Taxes estimated
  • Salaries (except if you have a payroll in arrears).
  • Some utility bills
  • Interest expenses

Prepaid expenses are anything you pay before you use them.

Also Read: Accrued Expense Journal Entry Explained With Examples

What Account Type Is a Prepaid Expense?

Now that you know what prepaid expenses journal entry is let’s know the account types. Prepaid expenses are a type of asset added to the balance sheet when a business makes advance payments for goods and services in the future. Although prepaid expenses are initially treated as assets, their value is eventually expensed onto the income statement.

Prepaying for expenses by a company is recognised on the balance sheet as a prepaid asset. A simultaneous entry is also recorded, which reduces the company's cash (or payments account) by the same amount. Prepaid expenses are generally considered a current asset on the balance sheet unless they are not incurred for more than 12 months, and this is very rare.

Adjustments for Prepaid Expenses

Before a company issues its financial statements, it should adjust the current assets account Prepaid Expenses balance.

The balance in Prepaid Expenses must adjust if financial statements are issued at the end of each month. This will ensure that the balance sheet shows the actual amount that was prepaid (not expired) at that month's end. If financial statements are only issued quarterly, the balance in Prepaid expenses must reflect the prepaid amount (not expired) at each quarter's end.

Prepaid Expenses Journal Entry

A prepaid account such as Prepaid Insurance is debited when a payment is made that prepayment an expense. The cash account is then credited, which registers the prepayment as an asset on the company's balance sheets. A schedule of amortisation that corresponds with the actual incurring or consumption schedule for the prepaid asset is also created.

A journal entry for each expense incurred during an accounting period is posted at the end of that period. This journal entry credits Prepaid Insurance's prepaid account on your balance sheet and debits Insurance expenses on your income statement.

This records the expense incurred for the period and reduces prepaid assets by the equivalent amount.

Example of Adjusting Prepaid Costs

Consider that the company's only prepaid expense is its liability insurance policy premiums. Assume that the company paid ₹7,000 on December 1 for its insurance coverage, covering the period from December 1 to May 31. 

The company recorded the December 1 payment with a debit of ₹7,000 for Prepaid Insurance and a credit of ₹6,000 for Cash. The Prepaid account expenses must be adjusted on December 31 to reflect a balance of ₹5,000, as the amount prepaid decreases by ₹2,000 per month. 

To credit Prepaid Expenses of ₹2,000 or debit Insurance expenses of ₹2,000, an adjusting entry should be made as soon as possible.

How to Record Prepaid Expenses

 

 

 

As an example, we just looked at prepaid insurance expenses. Let's now look at prepaid rent, which is another common occurrence.

Let's say that you prepay six months of rent, totalling ₹7,000. You have already paid this amount, but you still haven't received the benefits. So, record a prepaid expense, and adjust it as you go.

Rent is your first bookkeeping entry. The rent is paid by debiting the prepaid expense account (prepaid rent) and then crediting the cash account to record the money sent.

You'll now create adjusting entries to record the expense at each month's beginning. Note: The first JE may occur immediately depending on when the prepayment was made. Credit the prepaid expense account for the journal entry, also known as a prepaid asset or rent expense account. This records the actual rent used for a month.

How to Record? Prepaid Expense Examples

Let's look at some examples of prepaid expenses and see how and why they are recorded.

Example 1

Most prepaid costs include monthly utility bills, rent and insurance. Let's look at insurance as an example.

Let's say that Bill's Retail Store pays its insurance premiums every six months. The policy is renewed after six months, and Bill then pays ₹700 for a seven-month extension. Bill is purchasing seven months of insurance when he makes his premium payment, which means that he pays for the benefits before he uses them.

Bill would thus record a ₹700 prepaid expense when he pays his seven-month premium. He would debit the prepaid account and credit the cash account with ₹700. Bill would then expense this prepaid insurance at the end of each month by deducting the insurance expense from his bank account and crediting it with ₹100

Bill records his expenses just as he uses the insurance. Bill's prepaid accounts in his seven-month policy will have been expensed by the end of the policy, and Bill will then be eligible to renew the policy.

Also Read: Branch Accounting Meaning, Types, Journal Entries and Examples

Example 2

Insurance is a great example of a prepaid expense because it is usually paid in advance. A company would pay ₹12,000 to cover 12 months of insurance, and the current asset it records at payment is ₹12,000 to reflect this prepaid amount. The company would record an expense of ₹1,000 each month and draw the prepaid assets by the same amount.

What Is Prepaid Expense Amortisation? What are their Working Criteria?

If we talk about amortisation accounts in Prepaid expenses, it can be helpful for the consumption of time for prepaid expenses. A prepayment plan is this part of the organisation's sheet of balance.

If you implement an amortisation schedule, it might decrease the common accrual account. For example, it means prepaid rent to zero. Once the accrual period ends, the costs will be transferred to the statement of the profit & loss.

Conclusion

Prepaid concepts follow the matching principle and wait to recognise expenses until they are incurred. This idea is consistent with accrual accounting, where income and expenses are recorded in their actual incurred period, not necessarily in the paid period. 

Now keep track of your cash flow and manage your incomes and expenses with ease by using the Cashbook app by Khatabook.

FAQs

Q: How to Create a Prepaid Expenses Journal Entry?

Ans:

If you want to create a prepaid expenses journal entry, the best method is to identify the expenses first and use adjusting entries. When you know that you’re going to use the prepaid item, reduce the prepaid expense account and further increase the actual expense account, and it’ll result in a perfect calculation.

Q: Prepaid Expenses Is Which Type of Account?

Ans:

The prepaid expense means a sort of asset available on a balance sheet. It means that the company/business is making payment in advance for buying goods/services that it’ll receive in future.

Q: What Are the Two Ways to Record Prepaid Expenses?

Ans:

One method for recording a prepaid expense is to record the entire payment in an asset account. A second method of recording a prepaid expense is to record the entire payment in the expense account.

Q: What Is the Definition of Prepaid Insurance

Ans:

Prepaid insurance is the portion of an insurance premium that has been paid in advance and has not expired as of the date of a company's balance sheet. 

This unexpired cost is reported in the current asset account, Prepaid Insurance. As the amount of prepaid insurance expires, the expired portion is moved from the current asset account, Prepaid Insurance, to the income statement account Insurance Expense. This is usually done at the end of each accounting period through an adjusting entry.

Q: What Is a Prepaid Expense?

Ans:

If we talk about prepaid expenses in a journal entry, prepaid expenses are services paid in advance of being received. It is a way to pay for a resource before it arrives.

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The information, product and services provided on this website are provided on an “as is” and “as available” basis without any warranty or representation, express or implied. Khatabook Blogs are meant purely for educational discussion of financial products and services. Khatabook does not make a guarantee that the service will meet your requirements, or that it will be uninterrupted, timely and secure, and that errors, if any, will be corrected. The material and information contained herein is for general information purposes only. Consult a professional before relying on the information to make any legal, financial or business decisions. Use this information strictly at your own risk. Khatabook will not be liable for any false, inaccurate or incomplete information present on the website. Although every effort is made to ensure that the information contained in this website is updated, relevant and accurate, Khatabook makes no guarantees about the completeness, reliability, accuracy, suitability or availability with respect to the website or the information, product, services or related graphics contained on the website for any purpose. Khatabook will not be liable for the website being temporarily unavailable, due to any technical issues or otherwise, beyond its control and for any loss or damage suffered as a result of the use of or access to, or inability to use or access to this website whatsoever.

Disclaimer :
The information, product and services provided on this website are provided on an “as is” and “as available” basis without any warranty or representation, express or implied. Khatabook Blogs are meant purely for educational discussion of financial products and services. Khatabook does not make a guarantee that the service will meet your requirements, or that it will be uninterrupted, timely and secure, and that errors, if any, will be corrected. The material and information contained herein is for general information purposes only. Consult a professional before relying on the information to make any legal, financial or business decisions. Use this information strictly at your own risk. Khatabook will not be liable for any false, inaccurate or incomplete information present on the website. Although every effort is made to ensure that the information contained in this website is updated, relevant and accurate, Khatabook makes no guarantees about the completeness, reliability, accuracy, suitability or availability with respect to the website or the information, product, services or related graphics contained on the website for any purpose. Khatabook will not be liable for the website being temporarily unavailable, due to any technical issues or otherwise, beyond its control and for any loss or damage suffered as a result of the use of or access to, or inability to use or access to this website whatsoever.