Definition of Prepaid Expenses
Prepaid expenses refers to payments made in advance and part of the amount will become an expense in a future accounting period. A common example is paying a 6-month insurance premium in December that provides coverage from December 1 through May 31.
Examples of Two Methods for Recording Prepaid Expenses
One method for recording a prepaid expense is to record the entire payment in an asset account. For example, assume that on December 1 a company pays an insurance premium of $2,400 for 6 months of liability insurance coverage:
- On December 1 the company debits Prepaid Insurance for $2,400 and credits Cash for $2,400
- On the last day of December and on the last day of the following 5 months the company needs to record an adjusting entry that debits Insurance Expense for $400 ($2,400 divided by 6 months) and credits Prepaid Insurance for $400
A second method of recording a prepaid expense is to record the entire payment in the expense account. Using the information above, the following entries will occur:
- On December 1 the company debits Insurance Expense for $2,400 and credits Cash for $2,400
- On the last day of December the company records an adjusting entry that debits the asset account Prepaid Insurance for $2,000 ($2,400 divided by 6 months times the 5 months that will be prepaid as of December 31) and credits Insurance Expense for $2,000
- At the end of each of the following 5 months the adjusting entry will debit Insurance Expense for $400 and will credit Prepaid Insurance for $400
Either method for recording prepaid expenses could be used as long as the asset account balance is equal to the unexpired or unused cost as of each balance sheet date.