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.
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.
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.
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.
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.
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