Prepaid expenses (a.k.a. prepayments) represent payments made for expenses which have not yet been incurred.
In other words, these are "advanced payments" by a company for supplies, rent, utilities and others that are still to be consumed. Hence, they are included in the company's assets.
Expenses are recognized when they are incurred regardless of when paid. Expenses are considered incurred when they are used, consumed, utilized or has expired.
Because prepayments they are not yet incurred, they are not recorded as expenses. Rather, they are classified as current assets since they are readily available for use.
Prepaid expenses may need to be adjusted at the end of the accounting period. The adjusting entry for prepaid expense depends upon the journal entry made when it was initially recorded.
There are two ways of recording prepayments: (1) the asset method, and (2) the expense method.
Under the asset method, a prepaid expense account (an asset) is recorded when the amount is paid. Prepaid expense accounts include: Office Supplies, Prepaid Rent, Prepaid Insurance, and others.
In one of our previous illustrations (if you have been following our comprehensive illustration for Gray Electronic Repair Services), we made this entry to record the purchase of service supplies:
Take note that the amount has not yet been incurred, thus it is proper to record it as an asset.
Suppose at the end of the month, 60% of the supplies have been used. Thus, out of the $1,500, $900 worth of supplies have been used and $600 remain unused. The $900 must then be recognized as expense since it has already been used.
In preparing the adjusting entry, our goal is to transfer the used part from the asset initially recorded into expense – for us to arrive at the proper balances shown in the illustration above.
The adjusting entry will include: (1) recognition of expense and (2) decrease in the asset initially recorded (since some of it has already been used). The adjusting entry would be:
|Dec||31||Service Supplies Expense||900.00|
The "Service Supplies Expense" is an expense account while "Service Supplies" is an asset. After making the entry, the balance of the unused Service Supplies is now at $600 ($1,500 debit and $900 credit). Service Supplies Expense now has a balance of $900. Now, we've achieved our goal.
Under the expense method, the accountant initially records the entire payment as expense. If the expense method was used, the entry would have been:
|Dec||7||Service Supplies Expense||1,500.00|
Take note that the entire amount was initially expensed. If 60% was used, then the adjusting entry at the end of the month would be:
|Service Supplies Expense||600.00|
This time, Service Supplies is debited for $600 (the unused portion). And then, Service Supplies Expense is credited thus decreasing its balance. Service Supplies Expense is now at $900 ($1,500 debit and $600 credit).
Notice that the resulting balances of the accounts under the two methods are the same (Cash paid: $1,500; Service Supplies Expense: $900; and Service Supplies: $600).
GVG Company acquired a six-month insurance coverage for its properties on September 1, 2016 for a total of $6,000.
Under the asset method, the initial entry would be:
On December 31, 2016, the end of the accounting period, part of the prepaid insurance already has expired (hence, expense is incurred). The expired part is the insurance from September to December. Thus, we should make the following adjusting entry:
Of the total six-month insurance amounting to $6,000 ($1,000 per month), the insurance for 4 months has already expired. In the entry above, we are actually transferring $4,000 from the asset to the expense account (i.e., from Prepaid Insurance to Insurance Expense).
If the company made use of the expense method, the initial entry would be:
In this case, we must decrease Insurance Expense by $2,000 because that part has not yet been incurred (not used/not expired). Insurance Expense shall then have a balance of $4,000. The amount removed from the expense shall be transferred to Prepaid Insurance. The adjusting entry would be:
What we are actually doing here is making sure that the incurred (used/expired) portion is included in expense and the unused part into asset. The adjusting entry will always depend upon the method used when the initial entry was made.
If you are having a hard time understanding this topic, I suggest you go over and study the lesson again. Sometimes, it really takes a while to get the concept. Preparing adjusting entries is one of the challenging (but important) topics for beginners.