What are prepaid assets? – Definition
Prepaid assets are nonmonetary assets whose benefits affect more than one accounting period. They include items such as prepaid insurance and prepaid rent and essentially represent the right to receive future services. However, the rights to these future benefits or services rarely last more than two or three years.
The matching convention requires allocation of the expenditure between the asset that represents the remaining economic benefits and the expense that represents the benefits used or consumed by the firm. The services represented by prepaid assets are a function of time, So the allocation process is closely related to the term of service.
The purchase of prepaid insurance will serve as an example. Assume that the Smith Company, which has a yearly accounting period ending on December 31, chases on April 1, 2019, a two-year comprehensive insurance policy for $2,400; When the Insurance policy is purchased, the debit is to the asset account, Prepaid Insurance. The original journal entry, as well as the adjusting entry and the relevant T accounts, are illustrated below.
To adjust prepaid insurance for 9 months. Amount of Journal entry:
= Cost of insurance / Number of months benefits received
= $2,400 / 24 month
Adjusting entry = 9 months x $100
If we assume that the entire original expenditure for insurance was recorded in the asset account, Prepaid Insurance, it is necessary on December 31 to decrease the asset account by the amount of insurance that has expired. In this case, assuming that the service represented by the asset expires equally each month, the Prepaid Insurance account must be reduced by $900. The balance of $1,500 in the Prepaid Insurance account represents the future benefits of the insurance policy, and the $900 balance in the Insurance Expense account represents the amount of benefits that have expired.
The adjusting entry for prepaid rent or other prepaid assets follows a similar process. When you begin to make adjusting entries for prepaid assets, you should follow these steps:
1. Determine the amount of the estimated monthly benefits to be received from the asset, using this general formula:
2. Write off the appropriate amount of the asset used, based on the date that the asset was acquired and thc length of the accounting period. The adjusting entry decreases the asset account and records an expense for the amount of benefits that have been used or have expired.