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 future. Prepaid expenses are initially recorded as assets, but 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 a company that had an annual insurance expense of $1,200. As each month elapses, $100 of prepaid insurance would be expensed to the income statement until the account is empty at year's end.
Recording Prepaid Expenses
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. Instead, they must be recorded as assets on the balance sheet at the time of their purchases before being used or consumed. To record a prepayment, companies debit the equipment or insurance policy account, and credit the cash account, assuming no trade credit — an agreement in which a customer can purchase goods on account (without paying cash), paying the supplier at a later date — is used. This effectively increases the amount in the prepaid-expense asset account and reduces the cash balance.
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 adjust certain previously recorded transactions. Adjusting entries for prepaid expenses are necessary 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, companies 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.