A prepaid expense is an expense which has been paid in advance.
A business has an annual premises rent of 60,000 and pays the landlord quarterly in advance on the first day of each quarter. On the 1 January it pays the next quarter rent of 15,000 to cover the 3 months of January, February, and March. It has a prepaid expense of 15,000.
The recording of the prepaid expense is in two parts:
- The payment of cash to create the prepayment on the 1 January.
- The adjusting entry at the end of January to reflect the rent expense of 5,000 for that month.
1. Journal Entry to Record the Payment.
To record the payment of cash which created the prepaid expense, the accounting records will show the following bookkeeping entries on 1 January:
| Account | Debit | Credit |
|---|---|---|
| Prepayment | 15,000 | |
| Cash | 15,000 | |
| Total | 15,000 | 15,000 |
Prepayment Double Entry
Debit
The debit is to the prepayment account which represents an asset. The business has the right to use the premises for the following 3 month period.
Credit
The credit represents a reduction in cash which has been used to make the prepayment.
Prepaid Expense Accounting Equation
The Accounting Equation, Assets = Liabilities + Owners Equity means that the total assets of the business are always equal to the total liabilities plus the total equity of the business This is true at any time and applies to each transaction. The following table shows the Accounting Equation for this transaction.
In this case one asset (prepayments) has been increased by 15,000 and the other (cash) has been reduced by a similar amount.
2. Prepaid Expense Journal Entry
At the end of January one third of the prepaid rent expense will have been used up as the business has used the premises. This must now be expensed to the income statement for January. The prepaid expense accounting is as follows:
| Account | Debit | Credit |
|---|---|---|
| Expense | 5,000 | |
| Prepayment | 5,000 | |
| Total | 5,000 | 5,000 |
Prepaid Expense – Bookkeeping Entries Explained
Debit
The debit is to the expense account. The business has used the premises for 1 month and the cost of doing so must be expensed to the income statement.
Credit
The credit is to the prepayment (asset) account. This represents a reduction in the asset as the business now only has the right to use the premises for the following 2 month period.
This journal would be repeated at the end of February and March. At that point 15,000 has been expensed to the income statement and the prepayment account balance has been reduced to zero.
The Accounting Equation
The Accounting Equation, Assets = Liabilities + Owners Equity means that the total assets of the business are always equal to the total liabilities plus the total equity of the business This is true at any time and applies to each transaction. The following table shows the Accounting Equation for this transaction.
In this case the asset (prepayments) has been reduced by 5,000 and the income statement has been charged with the 5,000 as a rent expense. The charge to the income statement reduces the net income which reduces the retained earnings and therefore the owners equity in the business.
Further details on the treatment of prepaid expenses are available in our prepaid expenses tutorial.
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About the Author
Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.