Prepaid Expenses

Prepaid accounting results from one of the fundamental accounting principles, the matching or accruals concept which sets out that expenses are matched to revenues.

Prepaid expenses occur when a payment is made and the cost is not entirely used up during the accounting period. In these circumstances, it would be incorrect to charge the full cost to the accounting period as it would not match the revenue for the accounting period.

Prepaid Expenses Example

As an example, to get a better rate, a business might choose to pay its insurance premium in advance. Assuming the insurance is paid for a period of eighteen months at a total cost of 5,400, then the following prepaid expenses journal would be used to record the payment.

Prepaid insurance journal
Account Debit Credit
Insurance expense 5,400
Cash 5,400
Total 5,400 5,400

The balance on the insurance expense account is 5,400, the full cost for the eighteen month period of the policy. The insurance cost overlaps two accounting periods.

Prepaid expenses overlaps two accounting periods
Year 1 Year 2
Insurance cost (5,400)

In order to comply with the matching concept, the business must match the expense to the revenue, and charge twelve months of the insurance cost as an expense in year 1, and move six months of the cost to a prepaid insurance account. The calculations are done pro rata as follows:

Insurance expense = 5,400 x 12 / 18 = 3,600
Prepaid insurance = 5,400 x 6 / 18 = 1,800
Prepaid expenses
Year 1 Year 2
Insurance expense (3,600) Prepaid (1,800)

The prepaid expenses journal entry to post the insurance is as follows:

Prepaid insurance expense
Account Debit Credit
Prepaid insurance 1,800
Insurance expense 1,800
Total 1,800 1,800

The insurance expense account is reduced from 5,400 to the expense for the year of 3,600, and the amount of 1,800 is transferred to the prepaid insurance account. The prepaid insurance is an asset of the business and is shown on the balance sheet under current assets, it is something the business has paid for but not yet used.

The double entry accounting journals used above are more fully explained in our prepaid expense journal entry example.

Prepaid expenses also arise when a business buys items such as stationery for use within the business. At the end of the accounting period, any stationery not used up is held as inventory, and a prepaid expense journal entry is made to transfer this prepaid stationery from expenses to stationery inventory.

Prepaid stationery expense
Account Debit Credit
Stationery Inventory (prepayment) XXX
Stationery expense XXX

Again, the stationery inventory is an asset of the business and is shown in the balance sheet under current assets, together with other prepaid expenses (it is not shown as part of the trading goods inventory, as it is not being held for resale.

Prepaid Expenses November 6th, 2016Team

You May Also Like

Related pages

available for sale securities accounting journal entriespayment voucher templatesexcel spreadsheet for bookkeepingdirect material usage variance formulachart of accounts excelarr calculation formulamarketable securities available for saleworking capital sales ratioformula straight line depreciationaccounting template excelthe rule of 78sjournal entry of bills receivabledouble entry bookkeeping books free downloadgoods held on consignmentfuture value of perpetuity formulaoffice supplies adjusting entrycost of goods manufactured formula accountingsubsidiary ledger templatedifference between profit margin and markupannuity npv formulajournal entry for unrealized gain on trading securitiesmultiple step income statement templatehow to calculate operating capitalhow to do closing entries in accountingcheque examplesbookkeeper dictionaryaccruals and deferred income balance sheetcalculate unit contribution margindaily time sheet templatetransactional analysis for dummiesaccounting t accounts templatecalculate annuity factorprepaid expenses and accrued expensessubscribed capital stock definitionaging account receivablecurrent ratio example from balance sheetobsolete inventory accountingformat of sales ledger control accounthow to calculate an annuity factorannuity tables present valueconstant in excel formulahow to calculate fixed cost and variable costnper formula excelexcel depreciation schedulephysical inventory count sheetsum of annuity formulaexample of bookkeeping recordsrent receivable journal entryan example of an accrued revenue iswhat is the purpose of closing entrieslessor accounting exampleaccruing expensesformat of trial balance in accountingcompound depreciation formuladiscount on bond payableconsignee accountcalculating reducing balance depreciationcapital lease calculatormark up and profitcredit entry to accounts receivablestatement of retained earninghorizontal and vertical analysis of a financial statementledger samplepayback analysis excelequation quizannuity tablesunsecured loans in balance sheetreceivable turnover ratio calculatorbasic accounting spreadsheethow to journalize notes payabledepreciation amortisationconvert cash calculatorhow to calculate cash flow in excelmicrosoft excel accounting templateshow to calculate bank reconciliation statement