Introduction

 Sometimes the companies pay for the expenses in advance before the expenses become due. This may be due to some discount being offered or longer subscription or validity being offered. They haven’t been recorded by the company as an expense, but have been paid in advance.

They are initially recorded as assets and as they become due, they are reduced from the expenses balance as per matching concept. They are prepayments made by the company. 

What is Prepaid Expense?

Prepaid expenses are expenses which haven’t been made yet due but paid in advance. They accrue when we pay for something that we will receive in the near future. They don’t provide right at instant time rather in a future course of time. They arise in accrual-based accounting only.

They turn into expenses when we actually use them. As we use, the value of asset usually decreases. The value of asset is then changed with actual expense recognized in the income statement.

The utilization of prepaid expenses happens by charging proportionate amounts to expense accounts. Since these expenses would bring in profits in the future, they are charged against profits of the company.

Steps involved in journal entry of prepaid expenses:

Step 1: Create Advance Payment Invoice

Debit: Prepaid expense

Credit: Liability

(Proforma invoice being received and payment to be made)

Step2: Payments of prepaid expenses

Debit: Liability A/C

Credit: Cash/Bank

(Advance payment being made)

Step 3: Invoiced for expenses

Debit: Expense A/C

Credit: Prepaid Expense A/C

(Expense charge being created and prepaid expense reduced)

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Journal Entry of Prepaid Expense:

Prepaid expense is an asset and are increased when debited. Either cash is credited or bank account is credited with prepaid expense. The journal entry required to record the prepaid expense is:

At the time of payment:

ParticularsDrCr
Prepaid Expense A/C Drx,xxx 
      To Cash/ Bank A/C x,xxx

Adjustment entry:

ParticularsDrCr
Expense A/C Drx,xxx 
      To Prepaid Expense A/C  x,xxx

Such expenses are shown on the asset side of balance sheet under Current Assets heading.

Prepaid expense as Current asset:

Current assets are assets that can be readily converted into cash within a year or a working capital cycle.

Current assets include cash, inventory, debtors, prepaid expenses.

Prepaid expenses fulfill the recognition criteria of asset i.e.

  • It is probable that any future benefit associated with the asset will flow to the entity
  • The value of the asset can be measured reliably.

 In the case of prepaid expenses, the above criteria are easily fulfilled. Hence, it is treated as an asset.

Example of prepaid expenses:

Prepaid expenses include the following:

  • Prepaid rent
  • Prepaid supplies
  • Prepaid insurance
  • Prepaid interest
  • Prepaid taxes etc.

Recording prepaid expenses in the financial statements:

Let us understand the procedure of recording prepaid expenses with an illustration:

Hari pays 3 months advance rent for 2021 in the beginning of year Jan 3, 2021 of USD15,000 per month and would clear the remaining bill in due time. How to make entries for this transaction?

Initial entry to recognize the payment of advance rent in cash would be:

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ParticularsDrCr
Prepaid rent45,000 
      To Cash/ Bank 45,000

At the time of recognition of rent expense and payment of all rent due at the end of year:

ParticularsDrCr
Rent expenses180,000 
      Cash/ Bank 135,000
      Prepaid Rent 45,000

Presentation in the income statement:

Present expenses are not recorded in the income statement since they are the balance sheet account and effect only balance sheet. Prepaid expenses will allocate to income statement normally at the time of the end of the rental contract.

Total rental expenses amounting to USD180,000 will charge to income statement for the whole year or USD15,000 per month.

Presentation in the balance sheet:

The amount of USD45,000 would be shown in balance sheet under the current assets as follows:

                                                                Extract of asset side of balance sheet

AssetAmount
Current assets             
          Prepaid rent45,000

The similar entries can be passed for prepaid insurance recording as well. Initial entry to recognize the payment of advance insurance payment in cash would be:

ParticularsDrCr
Prepaid insurancexxxx 
      Cash/ Bank xxxx

At the time of recognition of insurance expense and payment of all rent due at the end of year:

ParticularsDrCr
InsuranceXXXX 
      To Cash/ Bank XXXX
       To Prepaid insurance XXXX

Presentation in the income statement:

Rent is charged to debit side of P&L account as insurance is recorded as expense. Prepaid insurance is then deducted from the value of insurance account.

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                                               Extract of debit side of Income statement

ParticularsAmount
To insurance A/C XXXX             
 Less: Prepaid insurance XXXXXXXXXX

Presentation in the balance sheet:

The amount of USD45,000 would be shown in balance sheet as follows:

                                                                Extract of asset side of balance sheet

AssetAmount
Current assets
          Prepaid insuranceXXXXX