Pre Paid Expense Meaning, Journal entry and Effect on financial statements

While checking or analysing financial statements, we always do find the word pre paid following by either rent, expense or insurance. We will simplify this in this simple article with examples

 

Table of Contents

  1. What is Prepaid Expense?
  2. Understanding Prepaid Expense
  3. Effect of Prepaid Expenses on financial statements
  4. Example

What is Prepaid Expense?

Prepaid expenses entry, represent expenditures that have not been recorded by a company as an expense but have been paid for in advance. A prepaid expense is a type of asset on the balance sheet that results from a business making advanced payment for the provided goods and services that would be received in the future. Prepaid expenses are expenditures in one accounting period, and they will not be recognized until a later accounting period. The value of prepaid expense is expensed over time onto the balance sheet. The most common examples of prepaid expenses are prepaid rent and prepaid insurance.

Pre Paid expenses are always shown in the asset side, because the other party who we have paid in advance is liable to provide us the service in the future. Hence its liability for the other party and asset for us

Meaning

According to the GAAP (Generally Accepted Accounting Principles), the expense should be recorded in the same accounting period as the benefit generated from the related asset. For example, if a large copying machine is leased by a company for a period of 12 months, the company benefits from its use over the full-time period. Recording an advanced payment made for the lease as an expense in the first month would not adequately match expenses with revenues generated from its use. Therefore, it should be recorded as a prepaid expense and allocated out to expense over the full twelve months. Due to the nature of certain goods and services, prepaid expenses will always exist. For example, insurance will always be a prepaid expense as it provides financial protection in the event of any unfortunate incident in the future. No insurance company would sell insurance that covers all the expenses after the unfortunate incident, so expenses must be prepaid.

Prepaid Rent Journal Entry

As discussed all that it is, is cash paid in advance for a particular period like a quarter, year, month etc. The pre paid rent journal entry would be as follows:

Date Account Debt Credit
31/03/2021 Pre Paid Rent 5000  
31/03/2021 Cash   5000

The adjustment entry after the rent period actually becomes current period will be

Date Account Debt Credit
31/06/2021 Rent Expense 5000  
31/06/2021 Pre Paid Rent   5000

 Pre paid insurance Journal Entry

In the same way pre paid insurance would be dealt, however insurance is charged in the statemetns on a straight line amortisation. When the pre paid insurance is paid, the expense account is credited and the pre paid insurance account is debted

Date Account Debt Credit
31/03/2021 Insurance expense account 2000  
31/03/2021 Pre paid insurance account   2000

Effect of  on Financial Statements

Initial journal entries do not affect the company’s financial statements. Prepaid rent and credit to cash are asset accounts and do not increase or decrease a company’s balance sheet. Prepaid expenses provide future economic benefits to the company. For example, $120,000 rent of a warehouse is expensed $10,000 monthly on a balance sheet. 

Example

Assume a company ABC purchases insurance for the upcoming 12-month period and pays $180,000 upfront for it. ABC Company will initially book the full $180,000 as a debit to prepaid insurance, an asset on the balance sheet, and a credit to cash. Each month, an adjusting entry will be made to expense $15,000 (1/12 of the prepaid amount) to the income statement through a credit to prepaid insurance and a debit to insurance expense. In the 12th month, the final $15,000 will be fully expensed and the prepaid account will be zero.

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