Prepaid accounting results from one of the fundamental accounting principles, the matching or accruals concept which sets out that expenses are matched to revenues.
Prepaid expenses occur when a payment is made and the cost is not entirely used up during the accounting period. In these circumstances, it would be incorrect to charge the full cost to the accounting period as it would not match the revenue for the accounting period.
Prepaid Expenses Example
As an example, to get a better rate, a business might choose to pay its insurance premium in advance. Assuming the insurance is paid for a period of eighteen months at a total cost of 5,400, then the following prepaid expenses journal would be used to record the payment.
The balance on the insurance expense account is 5,400, the full cost for the eighteen month period of the policy. The insurance cost overlaps two accounting periods.
|Year 1||Year 2|
|Insurance cost (5,400)|
In order to comply with the matching concept, the business must match the expense to the revenue, and charge twelve months of the insurance cost as an expense in year 1, and move six months of the cost to a prepaid insurance account. The calculations are done pro rata as follows:
Insurance expense = 5,400 x 12 / 18 = 3,600 Prepaid insurance = 5,400 x 6 / 18 = 1,800
|Year 1||Year 2|
|Insurance expense (3,600)||Prepaid (1,800)|
The prepaid expenses journal entry to post the insurance is as follows:
The insurance expense account is reduced from 5,400 to the expense for the year of 3,600, and the amount of 1,800 is transferred to the prepaid insurance account. The prepaid insurance is an asset of the business and is shown on the balance sheet under current assets, it is something the business has paid for but not yet used.
The double entry accounting journals used above are more fully explained in our prepaid expense journal entry example.
Prepaid expenses also arise when a business buys items such as stationery for use within the business. At the end of the accounting period, any stationery not used up is held as inventory, and a prepaid expense journal entry is made to transfer this prepaid stationery from expenses to stationery inventory.
|Stationery Inventory (prepayment)||XXX|
Again, the stationery inventory is an asset of the business and is shown in the balance sheet under current assets, together with other prepaid expenses (it is not shown as part of the trading goods inventory, as it is not being held for resale.
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 in 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 BSc from Loughborough University.