Prepaid Expense

What Is a Prepaid Expense?

A prepaid expense is a type of asset on the balance sheet that outcomes from a business making advanced payments for goods or services to be received from here on out. Prepaid expenses are initially recorded as assets, yet their value is expensed after some time onto the income statement. Not at all like conventional expenses, the business will receive something of value from the prepaid expense throughout the span of several accounting periods.

Grasping Prepaid Expenses

Organizations make prepayments for goods or services like leased office equipment or insurance coverage that give nonstop benefits after some time. Goods or services of this nature can't be expensed promptly in light of the fact that the expense wouldn't agree with the benefit incurred after some time from utilizing the asset.

As per generally accepted accounting principles (GAAP), expenses ought to be recorded in a similar accounting period as the benefit produced from the connected asset. For instance, in the event that a large replicating machine is leased by a company for a period of 12 months, the company benefits from its utilization throughout the full time span. Recording an advanced payment made for the lease as an expense in the primary month wouldn't sufficiently match expenses with incomes created from its utilization. Subsequently, it ought to be recorded as a prepaid expense and allocated out to expense over the full twelve months.

Journal passages that perceive expenses connected with recently recorded prepaids are called adjusting entries. They don't record new business transactions however just change recently recorded transactions. Adjusting passages for prepaid expenses are important to guarantee that expenses are recognized in the period in which they are incurred.

Due to the idea of certain goods and services, prepaid expenses will constantly exist. For instance, insurance is a prepaid expense in light of the fact that the purpose of purchasing insurance is to buy proactive protection in case something sad occurs from here on out. Obviously, no insurance company would sell insurance that covers a lamentable event afterward, so insurance expenses must be prepaid by businesses.

Illustration of Prepaid Expense

For instance, expect ABC Company purchases insurance for the impending year period. It pays $120,000 upfront for the insurance policy. ABC Company will initially book the full $120,000 as a debit to prepaid insurance, an asset on the balance sheet, and a credit to cash. Every month, an adjusting entry will be made to expense $10,000 (1/12 of the prepaid amount) to the income statement through a credit to prepaid insurance and a debit to insurance expense. In the twelfth month, the last $10,000 will be fully expensed and the prepaid account will be zero.