Do you ever pay for business goods and services before you use them? If you have done so, these types of purchases require special attention in your books.
What Are Prepaid Expenses?
Prepaid expenses can be defined as expenses paid for in advance. It is accrued when you pay for a product or service that you will receive in the near future. In accounting, anytime you pay for something before using it, you must recognize it through prepaid expenses accounting.
Prepaid expenses do not give value instantly. Instead, they give value over time—generally over multiple accounting periods. Since the expense expires as you use it, you can’t convert the entire value of the item to an expenses immediately. You can only expense the part that you’ve used. Record a prepaid expense in your accounting book and adjust the entries as you use the item.
So, do you know how to record prepaid expenses in your books? If you don’t know, don't panic, this article will guide you through the concept of prepaid expenses.
Also Read: Various Steps Of Accounting Cycle
Recording prepaid expenses only happens in accrual system of accounting due to the fact that in cash-basis accounting system, transactions are recorded when money physically changes hands.
What Is Considered A Prepaid Expense?
Individuals and businesses can accrue prepaid expenses. In small businesses, some purchases are considered prepaid expenses. The list below shows common prepaid expenses examples:
- Rent (when you pay for a commercial space before using it)
- Small business insurance policies
- Equipment you pay for before use
- Salaries in advance (except you run payroll in arrears)
- Estimated taxes
- Some utility bills
- Interest expenses
Is A Down Payment A Prepaid Expense?
Down payment is not a prepaid expense. To prepay for an item means that you are paying the full price before you have the product/receive the service, while a down payment is just paying a portion of the full price either ahead of time or at the time of purchase, while you pay for the remainder later.
Also Read: How To Become An Accountant Without A Degree
What Type Of Account Is Prepaid Expense?
You might be wondering what type of account is a prepaid expense. Just to remind us, the main types of accounts are assets, liabilities, equity, expenses and revenue. You can also see our article on the different types of accounts.
Maybe you might be thinking that it’s an expense, right? Although that’s a fair assumption, but it is not correct. A prepaid expense is an asset. Yes, it is. So, where are prepaid expenses recorded on the balance sheet? Prepaid expenses are shown on the assets side of balance sheet.
Amortization of Prepaid Expenses
Prepaid expenses change into expenses when you actually use them. As you use the item, you decrease the value of the asset. Hence, the value of the asset is replaced with an actual expense recorded on the income statement of the company.
Amortization can be defined as paying off a debt in a given period in equal installments. With amortization, the amount of accrual, such as prepaid rent, is gradually reduced to zero, through amortization schedule. The expense is then transferred to the income statement for the period during which the company uses up the accrual.
My point here is that before you use a prepaid expense item, it’s an asset. But as soon as they are used, it becomes an expense.
Prepaid Expenses Journal Entry
Open a prepaid expenses journal entry in your books at the time of purchase, before using the good or service.
Before taking you into the world of journal entries, you need to understand how each main account is affected by debits and credits.
Note: Assets and expenses are increased by debits and decreased by credits. On the contrary, liabilities, equity, and revenue are increased by credits and decreased by debits.
How Do You Record Prepaid Expenses?
The first step to create your first prepaid expenses journal entry is to debit your prepaid expense account. Why should you do that? Because it is an asset account, and assets are increased by debits. And for every debit entry, there must also be a corresponding credit entry. You can read more of our article on the double entry accounting system. Credit the corresponding account you used to make the payment for the expenses, either in cash or bank account. Crediting the account decreases your cash or bank account. Since when making payment, money is going out.
I guess this might seem a little difficult to understand, so let me explain it with an example.
Assuming your business purchases insurance for 8 months for $800. To create the journal entry for this transaction, you must first know the account that will be debited and the account to be credited. From the illustration above, you will debit the Prepaid Insurance account for $800.
Why will it appear on the debit side? Because prepaid insurance is an asset account, and as we stated earlier, assets are increased by debits. This means that whenever there is an increase in assets, the assets account should be debited.
Then, to balance the transaction, you have to credit cash for $800, since it decreases. Whenever there is a decrease in the value of asset, the asset account should be credited.
The journal entry should look like this:
Adjustments For Prepaid Expenses
Adjusting entries help balance your books. Use adjusting entries to recognize prepaid expenses that become actual expenses.
As you use up the prepaid item, decrease the value of your prepaid expense account and increase the value of your actual expense account. To do this, debit your expense account and credit your prepaid expense account. A prepaid expense adjusting entry will be created.
Your journal entry reflecting the actual expense should look like this:
Let’s say you prepay six month’s worth of rent, which adds up to $6,000. When you prepay rent, you record the entire $6,000 as an asset on the balance sheet. Each month, you reduce the asset account by the portion you use. You decrease the asset account by $1,000 ($6,000 / 6 months) and record the expense of $1,000.
Repeat the process until the expense is used up. As soon as you use all the prepaid item, the asset account should be empty while the expense account should show its full value.
How To Record A Prepaid Expenses
Prepaid expense journal entries help you keep accurate accounting books. Let us see some examples of prepaid expenses.
1. Prepaid Insurance Example
ABC Limited buys a 6-month insurance policy for $1200 at the start of the year. This prepaid expense is first recorded as an asset like this:
Since the insurance policy is valid for 6 months, then the corresponding expense for each month would be calculated as:
$1200 / 6 months = $200 per month
Hence, at the end of January, and for the next 6 months, there will be an adjusting entry as shown below:
2. Depreciation Example
ABC Limited purchases all of its equipment for $120,000 at the commencement of the business, with an estimated life of 6 years.
First, the prepayment for these pieces of equipment is recorded as an asset:
Using the straight-line method of depreciation, the business can unravel how much the equipment will have depreciated at the end of each year.
$120,000 / 6 years = $20,000 per year
So, the adjusting entry at the end of the year and for the next six years would look like this:
3. Prepaid Rent Example
ABC Limited secures a 9-month rent agreement in the month of January for $18,000. The journal entry for this prepayment is:
Since the rent agreement covers a 9-month accounting period, the corresponding expense for each month would be:
$18,000 / 9 months = $2000 per month
The adjusting entry at the end of January and each month for the next 9 months would look like this: