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Prepaid Expenses

Prepayment is payment made ahead of its due date. It is an amount paid for expenses such as rent, insurance, etc that will be incurred after the current accounting period. As the benefit of the rent, insurance, etc will only be enjoyed in the next period, the amounts paid for these expenses should be adjusted so that the prepaid portions are excluded when these expenses are transferred to the income statement. Failure to do this will understate the net profit.

The most common prepayment is the insurance premiums which are usually paid in advance of the coverage as stipulated in the insurance policy. The amount paid for an insurance includes payment for future coverage as the policy has not been fully used up or expired at the end of the accounting period. On the income statement, the amount for insurance expense should be for coverage for the current period. All payment in excess of this amount is obviously for coverage after this period and should be treated as prepayment. Prepayment comes under current asset on the balance sheet.

For example, a company makes a quarterly payment for liability insurance for its officers. The annual cost of the insurance is $1,200 and it covers the period from 1st March 20X1 to 28th February 20X2. Its financial year end is 31 December. The table below shows the details.

Quarterly amount Due date Date paid
$

300 1 March 20X1 6 March 20X1
300 1 June 20X1 7 June 20X1
300 1 September 20X1 4 September 20X1
300 1 December 20X1 3 December 20X1


Journal entry for the year-end adjustment:

Date Particulars Folio Debit Credit



$ $
20X1



Dec 31 Prepaid Insurance
200

Insurance Expense

200

(Insurance paid in advance)



General ledger:

Insurance Account

Date Particulars Folio Amount
Date Particulars Folio Amount



$



$
20X1



20X1


Jan 31 Prepaid insurance
100
Dec 31 Profit and Loss
1,200
Feb 28 Prepaid insurance
100
Dec 31 Prepaid Insurance
200
Mar 06 Bank
300




June 07 Bank
300




Sep 04 Bank
300




Dec 03 Bank
300
















1,400



1,400










Prepaid Insurance Account

Date Particulars Folio Amount
Date Particulars Folio Amount



$



$
20X1



20X1


Jan 01 Balance b/d
200
Jan 31 Insurance
100
Dec 31 Insurance
200
Feb 28 Insurance
100





Dec 31 Balance c/d
200












400



400









20X2







Jan 01 Balance b/d
200





Writing off prepayments as expenses

When prepayments occur within an accounting period, they become expenses through passage of time or when they are used up. For example, a company paid $1,500 quarterly for renting a warehouse. At the end of March, it paid $1,500 which was a prepayment for the three months from April to June. At the end of each of these months, the prepayment becomes an expense item and the following posting is carried out.

Debit rent account
Credit prepaid rent account

Journal entry for the month of April, 20XX

Date Particulars Debit Credit
20XX


Apr 30 Rent Expense 500

Prepaid Rent
500

(Rent paid in advance)


Rent Account

Date Particulars Folio Amount
Date Particulars Folio Amount



$



$
20XX







Apr 30 Prepaid Rent
500





Prepaid Rent Account

Date Particulars Folio Amount
Date Particulars Folio Amount



$



$
2088



20XX


Mar 28 Bank
1,500
Apr 30 Rent expense
500

If no adjustment is made to prepaid expenses as they expire or are used up, it will understate expenses, and overstate net income, profit and assets.

Last Updated (Thursday, 07 October 2010 16:03)