Prepaid Expenses: Definition

Unexpired or prepaid expenses are the expenses for which payments have been made, but full benefits or services have yet to be received during that period. 

Such payments fall into two portions. The first portion, comprising received benefits, is an expense.

As for the second portion, which involves the incoming benefits or services used in the coming period, this represents current assets, otherwise known as unexpired expenses, prepaid expenses, or expenses paid in advance.

At the end of the accounting period involving advance payment, the expired portion becomes part of the income statement like any other expense; the unexpired portion becomes part of the balance sheet like any other current asset.

Prepaid Expenses: Explanation

At the end of the year, there may be expenses whose benefits have been received but not paid for and expenses that may have been paid, but their benefit will appear in the next financial year.

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. 

The trial balance, drawn up on 31 December 2019, assumed that he had no other insurance and his insurance expenses account would show a balance of $4,800. However, only a part of this amount relates to 2019.

The premium covers twelve months from 1 September 2019 to 31 August 2020, i.e., four months of 2019 and eight months of 2020. It would be incorrect to charge the whole $4,800 to 2019’s profit and loss account. 

The correct insurance expenses for 2019 comprise 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. 

Although Mr. John’s trial balance does not disclose it, there is a current asset of $3,200 on 31 December 2019. Thus, what has been paid for remains an asset unless it is fully used.

Mr. John’s trial balance on 31 December 2019 will, therefore, require adjusting to show that:

  • The correct insurance expense for the year is less than the amount indicated by the trial balance
  • 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 accommodates a prepaid expense:

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

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

Prepaid Expenses Journal Entry

The above journal entry would have two effects:

  • When preparing the profit and loss account, insurance expenses will amount to $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

This method sees an expense paid in advance recorded as an asset. The payment of expense in advance increases one asset (prepaid or unexpired expense) and decreases another asset (cash).

The journal entry at the time of payment shows:

Prepaid Unexpired Expenses Journal

Adjusting Entry

An expired portion of prepaid expense increases the expense and decreases the asset by making the following adjusting entry at the end of the accounting period:

Prepaid Expense Adjustment

2. Expense Method

Entry at the Time of Cash Payment

This method initially records the advance payment as an expense by making the following journal entry:

Advance Payment Entry

Adjusting Entry

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

Adjusted Advance Payment

Example

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

Solution

Using the asset method
Using the asset method to record the advance payment for its insurance premium will record the whole amount of $1,800 as an asset by making the following journal entry on 1 October 2016:

Asset Method Journal

On 31 December 2016, the following adjusting entry will convert the expired portion of prepaid insurance (1,800 × 3/12 = $450) into an expense:

Expense Adjustment Example

Using the expense method
Using the expense method will record the whole amount of $1,800 as an expense by making the following journal entry on 1 October 2016:

Expense Method Journal
On 31 December 2016, making the following adjusting entry will convert the unexpired portion of insurance (1,800 × 9/12 = $1,350) into an asset:

Asset Conversion Entry

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

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

Frequently Asked Questions

Prepaid expenses vs. Accrued expenses

Prepaid expenses refer to an expense paid in advance while accrued expenses refer to a liability that is merely not yet due for payment or recorded as a liability on the balance sheet even though it has not been incurred.

Prepaid expense vs. Prepaid insurance

Prepaid expenses are like prepaid insurance which is a liability that can be recorded as either an asset or as an expense depending on the accounting policy adopted by the business.

Prepaid expense vs. Depreciation expense

Depreciation expenses are like prepaid expenses in that they allow for the smooth recording of expensed items throughout their useful lives. However, unlike prepaid expenses that can be recorded as either an asset or as an expense, Depreciation is only recorded as an expense and not as an asset.

Prepaid expense vs. unearned revenue

Unearned revenue refers to any money received by a company from the sale of goods or services but does not relate to any bill that has been paid in advance. Unearned revenue is not recorded as an asset like prepaid expense, instead it will be recorded as a liability on the balance sheet and increase earnings (i.E., Income) under Accrual Basis accounting.

Prepaid expense vs. Anticipated expenses

Anticipated expenses refer to expected future costs that must be recorded as a liability on the balance sheet. It is like accrued expenses but it differs in that money is not spent yet and nothing needs to be recorded as an expense.

True is a Certified Educator in Personal Finance (CEPF®), a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.

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