Adjusting entry for prepaid/unexpired expenses

Unexpired or prepaid expenses are the expenses for which payments have been made but full benefits or services have not been received during that period. Such payments can be divided into two portions. The portion for which benefits have been received is an expense and the portion for which the benefit is to be received or services are to be utilized in the coming period represents current asset and is known as unexpired expense, prepaid expense or expenses paid in advance.

At the end of accounting period in which advance payment is made, the expired portion becomes the part of income statement like any other expense and unexpired portion becomes the part of balance sheet like any other current asset.

Accounting process for prepaid or unexpired expenses

Prepaid or unexpired expenses can be recorded under two methods – asset method and expense method. The accounting process under both the methods is explained below.

(1). Asset method

Entry at the time of cash payment:
Under this method when an expense is paid in advance, it is recorded as an asset. By the payment of expense in advance, one asset (prepaid or unexpired expense) is increased and another asset (cash) is decreased. The journal entry at the time of payment is made as follows:

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Adjusting entry:
When a portion of prepaid expense is expired, the expense is increased and asset is decreased by making the following adjusting entry at the end of the accounting period:

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(2). Expense method

Entry at the time of cash payment:
According to this method, the advance payment is initially recorded as an expense by making the following journal entry:

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Adjusting entry:
At the end of the period if a portion of advance payment remains unexpired, the following adjusting entry is made to convert that portion into asset (i.e., prepaid expense):

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Example

The Blue Sky Sports Merchant closes its books on December 31. On October 1, 2016, It pays an insurance premium of $1,800 for a period of 12 months. What adjusting entry should be made in the books of Blue Sky on December 31, 2016.

Solution

If asset method is used:
I Blue Sky uses asset method to record the advance payment for its insurance premium, it will record the whole amount of $1,800 as an asset by making the following journal entry on October 1, 2016.

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On December 31, 2016, the expired portion of prepaid insurance (1,800 × 3/12 = $450) will be converted into expense by making the following adjusting entry.

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If expense method is used:
If Blue Sky uses expense method, the whole amount of $1,800 will be recorded as expense by making the following journal entry on October 1, 2016.

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On December 31, 2016, the unexpired portion of insurance (1,800 × 9/12 = $1,350) will be converted into asset by making the following adjusting entry.

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Notice that the amount for which adjustment is made is different under two methods but the final amounts are the same i.e., insurance expense $450 and prepaid insurance $1,350.

Impact on financial statements:
If Blue Sky prepares its financial statements on December 31, 2016, the expired portion of advance payment (i.e $450) will appear on income statement as an expense and unexpired portion (i.e., $1,350) will appear on the balance sheet as current asset.

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