Prepaid Expense

A prepaid expense is an expense which has been paid in advance.

A business has an annual premises rent of 60,000 and pays the landlord quarterly in advance on the first day of each quarter. On the 1 January it pays the next quarter rent of 15,000 to cover the 3 months of January, February, and March. It has a prepaid expense of 15,000.

The recording of the prepaid expense is in two parts:

  1. The payment of cash to create the prepayment on the 1 January.
  2. The adjusting entry at the end of January to reflect the rent expense of 5,000 for that month.

1. Journal Entry to Record the Payment.

To record the payment of cash which created the prepaid expense, the accounting records will show the following bookkeeping entries on 1 January:

Cash paid to create the Prepaid Expense
Account Debit Credit
Prepaid expense 15,000
Cash 15,000
Total 15,000 15,000

Prepaid Expense – Bookkeeping Entries Explained

Debit – What came into the business
An asset came into the business. The business has the right to use the premises for the following three month period.

Credit – What went out of the business
Cash went out of the business to pay the prepaid expense.

The Accounting Equation

The Accounting Equation, Assets = Liabilities + Owners Equity means that the total assets of the business are always equal to the total liabilities of the business This is true at any time and applies to each transaction. For this transaction the Accounting equation is shown in the following table.

Cash paid to create the Prepaid Expense
Assets = Liabilities + Owners Equity
Prepayments – Cash = None + None
15,000 – 15,000 = 0 + 0

In this case one asset (prepayments) has been increased by 15,000 and the other (cash) has been reduced by a similar amount.

2. Prepaid Expense Journal Entry

At the end of January one third of the prepaid rent expense will have been used up as the business has used the premises. This must now be charged to the profit and loss for January, the prepaid expense accounting is as follows:

Prepaid Expense Journal Entry
Account Debit Credit
Expense 5,000
Prepayments 5,000
Total 5,000 5,000

Prepaid Expense – Bookkeeping Entries Explained

Debit – What came into the business
The business had use of the premises for 1 month.

Credit – What went out of the business
The prepayment (asset) has been reduced.

This journal would be repeated at the end of February and March until the prepayment of 15,000 has been charged to the profit and loss and the prepayment account balance has been reduced to zero.

The Accounting Equation

The Accounting Equation, Assets = Liabilities + Owners Equity means that the total assets of the business are always equal to the total liabilities of the business This is true at any time and applies to each transaction. For this transaction the Accounting equation is shown in the following table.

Prepaid Expense – Accounting Equation
Assets = Liabilities + Owners Equity
Prepaid expense = None + Retained Earnings
-5,000 = 0 + -5,000

In this case the asset (prepayments) has been reduced by 5,000 and the income statement has been charged with the 5,000 as a rent expense. The charge to the income statement reduces the net income which reduces the retained earnings and therefore the owners equity in the business.

Further details on the treatment of prepaid expenses can be found in our prepaid expenses tutorial.

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