What are Prepaid Expenses?
Prepaid expenses are costs that have been paid in full for goods or services that will be used over a period of time. This kind of expense is usually intangible, such as an insurance premium, or can be tangible, such as prepaid rent. Prepaid expenses are recorded when the goods and services are paid for and not when they are used; otherwise, we might find ourselves with a deficit due to declining demand.
As a fund accounting student, you may experience some challenges when tackling the subject of prepaid expenses. The main reason is because of the accounting standards. The following guidelines will provide you with a framework that will assist in answering questions and completing problems that relate to this subject matter. If you experience further challenges you should not stress because financial homework help will assist you with all your classwork.
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What is Considered a Prepaid Expense?
Prepaid expenses are usually paid in advance. Prepaid expenses can be fixed or variable, depending on whether they will vary with the volume of the business. Prepaid expenses are also expected to benefit the business beyond one reporting period.
Prepaid expense account: prepaid expense account is also known as a prepaid maintenance and operating expenses account, which is a contra–asset account that records cash paid in advance for goods and services purchased but not yet consumed during an accounting period. Prepayment of insurance premiums, rent, etc., are credited to this account.
What type of account is prepaid expense? And where are they recorded?
Having the concept of accounting is very important especially when it comes to recording the prepaid expenses on the balance sheet.
On the balance sheet, prepaid expenses are first noted in the prepaid asset account. The prepaid expense is recognized as a current asset unless it won’t be incurred for another 12 months. When it’s recorded in the records as a current asset, we then show a contra-asset account for prepaid expenses. We also record the amount on the cash flow statement as an increase in operating activities.
How to Record Prepaid Expense as a Journal Entry
Before using the item or service, record a prepaid expenses journal entry in your books at the time of purchase.
You must comprehend how debits and credits affect each major account before you can fully appreciate the beautiful world of diary entries.
Debits result in a gain in assets, and credits result in a decrease in expenses.
Liabilities, equity, and revenue, on the other hand, are all enhanced by credits and diminished by debits.
Debit your Prepaid Expense account to record your first journal entry for prepaid expenses. How so? Since this account is an asset account, debits cause assets to grow. And there must be a credit for every debit. Credit the associated account, such as cash or checking account, that you used to make the payment. Your Cash or Checking account is reduced when you credit the account. When you incur the prepaid charge, you should record it as follows:
Initial journal entry for prepaid expense:
Adjusting journal entry as the prepaid expense expires:
Initial journal entry for prepaid insurance:
Adjusting journal entry as the prepaid insurance expires:
Prepaid Expenses Example
Below are two examples of prepaid expenses:
Dawson signs a one-year lease on a store for $8,000 a month. The landlord requires that Dawson Company pays the annual amount ($96,000) upfront at the beginning of the year.
The initial journal entry for Dawson’s Company would be as follows:
At the end of one month, Dawson Company would’ve used up one month of its lease agreement. Therefore, prepaid rent must be adjusted:
Take Note: One month corresponds to $8,000 ($96,000 x 1/12) in rent.
The adjusting journal entry is done each month, and at the end of the year, when the lease agreement has no future economic benefits, the prepaid rent balance would be 0.
Upon signing the one-year lease agreement for the store, Dawson Company also purchases insurance for the store. The company pays $24,000 in cash upfront for a 12-month insurance policy for the store.
The initial journal entry for Dawson Company would be as follows:
At the end of one month, Dawson Company would have used up one month of its insurance policy. Therefore, prepaid insurance must be adjusted:
To Note: One month corresponds to $2,000 ($24,000 x 1/12) in insurance policy.
The adjusting journal entry is done each month, and at the end of the year, when the insurance policy has no future economic benefits, the prepaid insurance balance would be 0.
What is the purpose of a Prepaid Journal Entry?
The prepaid journal entry serves great importance to accounting because it affects how an individual or organization runs its business. It is used to recognize that you have purchased, stored, and paid for a service in advance. The journal entry will show the price paid, the amount received, and what type of account it was credited to.
Why Prepaid Expenses Aren’t Initially on the Income Statement?
Prepaid expenses are not initially recorded on the income statement because they are not considered an expense or a revenue at the time of purchase. However, prepaid expenses must be recorded on the income statement when they are consumed or used by the company to record a change in financial position.
Prepaid expenses are recorded at their full value. A debit is entered for the expense and a credit is given for the asset. This is referred to as a contra-asset account or contra-expense account. For each debit, there will be a corresponding credit. If a company buys an asset or service for cash, you record it as a credit in the period of purchase and as an expense during the following year.
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