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