What is a 'Prepaid Expense'
A prepaid expense is a type of asset that arises on a balance sheet as a result of business making payments for goods and services to be received in the near future. While prepaid expenses are initially recorded as assets, their value is expensed over time as the benefit is received onto the income statement, because unlike conventional expenses, the business will receive something of value in the near future.
BREAKING DOWN 'Prepaid Expense'Due to the nature of certain goods and services, there must be prepaid expenses. For example, insurance is a prepaid expense, because the purpose of purchasing insurance is to buy proactive protection in case something unfortunate happens. Clearly, no insurance company would sell insurance that covers the occurrence of an unfortunate event after the fact, so insurance expenses must be prepaid.
An example of expensing prepaid expenses would be if a company had a one-year insurance policy cost of $1,200. As each month elapses, $100 of prepaid insurance would be expensed to the income statement until the account is empty at the end of the year.
Companies make prepayments for goods or services such as equipment or insurance coverage that provide continual benefits over time. Goods or services of this nature cannot be expensed immediately and entirely as a cost to revenue on the income statement in one single accounting period and must be recorded instead as assets on the balance sheet at the time of their purchases before being used or consumed. To record a prepayment, debit the equipment or insurance policy account, and credit the cash account, assuming no trade credit is used. This effectively increases the amount in the prepaid-expense asset account and reduces the cash balance.
The matching principle in accounting requires expenses be matched with revenues at the time an expense makes its contribution to revenue. In other words, expenses are recognized not necessarily when related payments are made but when the benefits from the expenses can be tied to the expected revenues. For example, as a piece of equipment depreciates after being deployed in use, periodic depreciation cost is recognized as an expense for each accounting period when the use of the equipment is actually contributing to each period's revenue generation. The approach to matching expenses is letting the expenses follow the revenues.
Journal entries used to record the recognition of expenses related to prior prepayments are called adjusting entries, which do not record new business transactions but simply adjust certain previously recorded transactions. Adjusting entries for prepaid expenses are needed to ensure that expenses are recognized in the period in which they are incurred. To record the adjusting entries for a prepayment at the end of an accounting period, debit the related, actual expense account to denote the expense recognition, and credit the asset account of the prepaid expense to reduce its outstanding balance. This process repeats until the prepaid expense is fully expensed over time.