Prepaid Expenses

Within a financial year, each time a portion of the expense is paid off, the prepaid account is gradually debited until the value becomes zero. Then, once the value of the asset gets completely utilised, the expense is shifted from the current asset account and is recorded as an expense. To illustrate prepaid insurance, let’s assume that on November 20 a company pays an insurance premium of $2,400 for insurance protection during the six-month period of December 1 through May 31.

On November 20, the payment is entered with a debit of $2,400 to Prepaid Insurance and a credit of $2,400 to Cash. Now, Due to the nature of certain goods and services, prepaid expenses will always exist. For example, insurance premium will always be a prepaid expense as it provides financial protection in the event of any unfortunate incident in the future. Also,No insurance company would sell you an insurance that covers all the expenses after the unfortunate incident, so expenses must be prepaid.

Where Do Prepaid Expenses Appear on the Balance Sheet?

One can easily track this during a period of accounting if there’s a prepaid account to reflect this expense. Prepaid expenses help businesses defer taxes to a later financial year. As per the rules of accounting, expenses can only be recorded when they are incurred. Hence, tax on an advance expense can only be deducted in the year to which it applies. Prepaid expenses represent payments made in advance for products or services expected to be incurred at a later date.

• Prepaid insurance is commonly recorded, because insurance providers prefer to bill insurance in advance.
• However, it is also reduced each year by the ever-growing accumulated depreciation.
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• For example, insurance premium will always be a prepaid expense as it provides financial protection in the event of any unfortunate incident in the future.
• The process of recording prepaid expenses only takes place in accrual accounting.

In other words, the ongoing business activity brings about changes in account balances that have not been captured by a journal entry. Time brings about change, and an adjusting process is needed to cause the accounts to appropriately reflect those changes. These adjustments typically occur at the end of each accounting period, and are akin to temporarily cutting off the flow through the business pipeline to take a measurement of what is in the pipeline. The journal entry for prepaid insurance is a debit to the prepaid insurance account and a credit to the cash account or the company’s bank account. This journal entry records the transaction concerning the purchase of insurance premiums by a company within a specified accounting cycle.

Adjusted Trial Balance

Therefore, timely and accurate adjustments to the prepaid insurance account are essential for correct financial statements per time. Failure to accurately make this distinction results in having incorrect final statements with either understated or overstated assets and expenses. The adjusting journal entry for a prepaid expense, however, does affect both a company’s income statement and balance sheet. The adjusting entry on January 31 would result in an expense of $10,000 (rent expense) and a decrease in assets of $10,000 (prepaid rent). The initial journal entry for a prepaid expense does not affect a company’s financial statements.

As one can see on each year’s balance sheet, the asset continues to be reported at its $150,000 cost. However, it is also reduced each year by the ever-growing https://www.bookstime.com/articles/prepaid-insurance-journal-entry accumulated depreciation. The asset cost minus accumulated depreciation is known as the book value (or “net book value”) of the asset.

Prepaid Expenses Examples

For example, the rent you pay for your office building is a prepaid expense. You don’t want to miss getting the space and hence pay the rent amount for a month or quarter in advance. The same journal will repeat for each month till December, when the balance in the prepaid rent account will be zero. Prepaid expenses are payments made in advance for goods or services that will be received or used in the future. As each month passes, adjust the accounts by the amount of rent you use.

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• Therefore, the same will be recorded as prepaid expenses in the company’s books of accounts in the accounting year in which it is paid.
• To illustrate prepaid insurance, let’s assume that on November 20 a company pays an insurance premium of $2,400 for insurance protection during the six-month period of December 1 through May 31.
• Company-B paid 60,000 rent (5,000 x 12 months) in the month of December which belongs to the next year and doesn’t become due until January of the following year.
• In other words, since $900 of supplies were purchased, but only $200 were left over, then $700 must have been used.

Company XYZ has paid an insurance expense of $500 for the next quarter. Prepaid expenses decrease the cash flow of a company for the current month; this may affect the payment of current expenses, and this may overall affect the net income. Expenses that are made for future assets always pose a threat of not getting utilised. For example, let’s say a rental agreement is violated, and the landlord terminates the remaining tenure.

Accounting Steps to Record Prepaid Insurance

Prepaid insurance appears in a company’s statement of financial position in the current asset segment as part of the prepaid expenses. As the insurance gets used up, an adjusting entry for prepaid insurance is made to account for the reduction in assets and the resultant increase in expenses. https://www.bookstime.com/ This increase in expenses reflects in the company’s income statement within the accounting period when it has been used up. Prepaid insurance refers to the payment made for insurance in advance. It is an expense that has not yet been recorded as an expense because it has not expired yet.

Typically, Prepaid Expenses which will expire within one year from the balance sheet date are listed in the current assets section of the Balance Sheet. Similarly, pre paid insurance would be dealt, however you would charge the insurance in the statemetns on a straight line amortisation. Also, When you pay the pre paid insurance , you would credit your expense account and the pre paid insurance account is debited. Long-lived assets like buildings and equipment will provide productive benefits to a number of periods.