Prepaid Expenses

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What are Prepaid Expenses? – Definition

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.

Explanation

Just as it is possible that at the end of the year there may be some expenses whose benefit has been received but they have not been paid for, it is also possible that some expenses may have been paid before the year-end but their benefit will be received in the next financial year.

Example

For example, on 1 September 2019, Mr. John bought a motor car and got it insured for one year, paying $4,800 as a premium. When he paid this premium, he debited his Insurance Expenses Account with the full amount, i.e. $4,800. When the Trial Balance is drawn up on 31 st December 2019, assuming that he had no other insurances, his Insurance Expenses Account would show a Dr. balance of $4,800. Yet, only a part of this amount relates to 2019.

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The premium covers twelve months from 1 September 2019 to 31st August 2020, i.e. four months of 2019 and eight months of 2020. It would be incorrect to charge the whole of $4,800 to 2019’s Profit and Loss Account. The correct insurance expenses for 2019 is 4/12th of $4,800 = $1,600. The balance, $3,200 (4,800 – 1,600) relates to 2020 and should be charged to that year’s Profit and Loss Account. Another important fact is that though Mr. John’s Trial Balance does not disclose it, there exists a current asset of $3,200 on 31 December 2019. This is so because what has been paid for remains an asset unless it is fully used up.

Mr. John’s Trial balance on 31 December 2019 will, therefore, need to be adjusted to show that:


(a) The correct insurance expense for the year is less than the amount shown by the Trial Balance, and that
(b) There exists a current asset in Mr. John’s favor of an amount equal to the value of unused, or unexpired, insurance.

Journal Entries for Prepaid Expenses

The following journal entry is made to accommodate a prepaid expense:

Dr. Prepaid Expense A/c (a newly opened account)
Cr. The Relevant Expenses Account With the amount that relates to the next year.

In Mr. John’s case, the journal entry would be:

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Journal Entry for Prepaid Expenses

The effect of the above journal entry would be two folds:

  • When preparing the Profit and Loss Account, Insurance Expenses will be shown at $1,600 ($4,800 less 3,200),
  • When preparing the Balance Sheet, Prepaid Insurance, $3,200 will be shown as a 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 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:

adjusting entries for prepaid or unexpired expenses

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:

adjusting-entry-prepaid-img3

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):

adjusting-entry-prepaid-img4

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.

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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.

adjusting-entry-img5

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.

adjusting-entry-prepaid-img6

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.

adjusting-entry-img7

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.

adjusting-entry-img8

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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