Instead, the value of the good or service must be recognized over time as the business realizes the benefit. Prepaid expenses are an asset because the business has not realized the value of the good or service when cash initially exchanges hands.

Under the accrual method of accounting, income is recognized when it is earned and expenses are recognized when incurred, regardless of when cash exchanges hands for the transaction. The $50,000 balance in prepaid expense appears on the balance sheet for the month, while the $10,000 rent expense appears on the income statement. The balance in the prepaid expense account at the end of the first month is, therefore, $50,000 and rent expense is $10,000. Both of these accounts are asset accounts, and the entire transaction affects the balance sheet only.ĭuring the first month of occupancy, the business records an adjusting journal entry to debit rent expense for $10,000 and credit prepaid expenses $10,000. Upon the initial payment, the journal entry recorded by the business debits $60,000 to prepaid expenses and credits $60,000 to cash. As part of the rental agreement, the landlord requests the business prepay six months' rent before occupying the property. Prepaid RentĪ business signs a rental agreement to open a new plant. Every month, the journal entry further decreases the prepaid expense account balance as the value of the coverage period is recognized by the business. The January month-end income statement reports $1,500 as the current period insurance expense. At the end of January, the prepaid expense account balance is $16,500 on the balance sheet. The journal entry debits an insurance expense account and credits prepaid expenses for $1,500. In January, the company records a journal entry to recognize 1/12 of the value of the insurance policy. This is fully a balance sheet transaction, as it does not involve any revenue or expense accounts that appear on the income statement. It simultaneously records an $18,000 credit to cash, which is also an asset account. When the business purchases the insurance policy in December, it records an $18,000 debit to prepaid expense, which is an asset account. InsuranceĪ business pays $18,000 in December for liability insurance covering January through December of the following year. Similarly, when a business signs a rental agreement with a landlord, it may include a stipulation to prepay a certain number of months' rent upfront. Many types of business insurance are paid as a lump sum in advance of a specific coverage period. Prepaid expenses usually provide value to a company over an extended period of time, such as insurance or prepaid rent. As the good or service is delivered, the asset's value is decreased, and the amount is expensed to the income statement. The business records a prepaid expense as an asset on the balance sheet because it signifies a future benefit due to the business. They usually relate to the purchase of something that provides value to the business over the course of multiple accounting periods. Office supplies provide an example of a prepaid expense that does not appear on another company's books as unearned revenue.Īccounting records that do not include adjusting entries to show the expiration or consumption of prepaid expenses overstate assets and net income and understate expenses.Prepaid expenses are amounts paid in advance by a business in exchange for goods or services to be delivered in the future. Prepaid expenses in one company's accounting records are often-but not always-unearned revenues in another company's accounting records. After one month, she makes an adjusting entry to increase (debit) insurance expense for $300 and to decrease (credit) prepaid insurance for $300. Initially, she records the transaction by increasing one asset account (prepaid insurance) with a debit and by decreasing another asset account (cash) with a credit. At the end of each accounting period, adjusting entries are necessary to recognize the portion of prepaid expenses that have become actual expenses through use or the passage of time.Ĭonsider the previous example from the point of view of the customer who pays $1,800 for six months of insurance coverage. For example, office supplies are considered an asset until they are used in the course of doing business, at which time they become an expense.

Prepaid expenses are assets that become expenses as they expire or get used up. Inventory Errors and Financial Statements.Inventory Systems: Perpetual or Periodic.Recording Notes Receivable Transactions.Subsidiary Ledgers and Special Journals.Generally Accepted Accounting Principles.

Prepaid expenses appear in the