Prepaid Expense

Prepaid expense is expense paid in advance but which has not yet been incurred.

Expense must be recorded in the accounting period in which it is incurred. Therefore, prepaid expense
must be not be shown as expense in the accounting period in which it is paid but instead it must be
presented as such in the subsequent accounting periods in which the services in respect of the prepaid
expense have been performed.

Entity should therefore recognize an asset in respect of expense it has paid in advance until such time as
the services that are due in relation to the prepaid expense have been performed by the
suppliers/contractors. Following accounting entry is required to account for the prepaid expense:

Debit Prepaid Expense (Asset)

Credit Cash

Example
ABC LTD pays advance rent to its landowner of $10,000 on 31st December 2010 in respect of office rent
for the following year. ABC LTD has an accounting year end of 31st December 2010.

ABC LTD will recognize an asset of $10,000 in the financial statements of year 2010 in respect of the
prepaid expense to recognize its right to use office space in the following year. Following accounting entry
will be recorded in the books of ABC LTD in the year 2010:

$ $
Debit Prepaid Rent 10,000
Credit Cash 10,000

The prepaid expense will be recognized as expense in the next accounting period to which the rental
expense relates. Following accounting entry will be recorded in the year 2011:

$ $
Debit Rent Expense (Income Statement) 10,000
Credit Prepaid Rent 10,000

Accrued expenses refer to expenses that are already incurred but have not yet been paid. At the end of
period, accountants should make sure that they are properly recorded in the books of the company.
Here's the rule. If a company incurred, used, or consumed all or part of an expense, that expense or part
of it should be properly recognized even if it has not yet been paid.
If such has not been recognized, then an adjusting entry is necessary.
Pro-Forma Entry
The pro-forma adjusting entry to record an accrued expense is:
mmm dd Expense account* x,xxx.xx
Liability account** x,xxx.xx
*Appropriate expense account (such as Utilities Expense, Rent Expense, Interest Expense, etc.)
**Appropriate liability account (Utilities Payable, Rent Payable, Interest Payable, Accounts Payable, etc.)
For Example
For the month of December 2014, Gray Electronic Repair Services used a total of $1,800 worth of
electricity and water. The company received the bills on January 10, 2015. When should the expense be
recorded, December 2014 or January 2015?
Answer in December 2014. According to the accrual concept of accounting, expenses are recognized
when incurred regardless of when paid. The amount above pertains to utilities used in December.
Therefore, if no entry was made for it in December then an adjusting entry is necessary.
Dec 31 Utilities Expense 1,800.00
Utilities Payable 1,800.00
In the adjusting entry above, Utilities Expense is debited to recognize the expense and Utilities Payable to
record a liability since the amount is yet to be paid.

Accrued Expense
Accrued expense is expense which has been incurred but not yet paid.
Expense must be recorded in the accounting period in which it is incurred. Therefore, accrued expense
must be recognized in the accounting period in which it occurs rather than in the following period in which
it will be paid.

As expense will be debited to record the accrued expense, a corresponding payable must be created to
account for the credit side of the transaction. The accounting entry to record accrued expense will
therefore be as follows:
Debit Expense (Income Statement)
Credit Expense Payable (Balance Sheet)

Prepaid Expenses Accounting

Definition of Prepaid Expenses

A prepaid expense is an expenditure paid for in one accounting period, but for which the underlying
asset will not be consumed until a future period. When the asset is eventually consumed, it is charged
to expense. If consumed over multiple periods, there may be a series of corresponding charges to
expense.
A prepaid expense is carried on the balance sheet of an organization as a current asset until it is
consumed. The reason for the current asset designation is that most prepaid assets are consumed
within a few months of their initial recordation. If a prepaid expense were likely to not be consumed
within the next year, it would instead be classified on the balance sheet as a long-term asset (a
rarity).

An example of a prepaid expense is insurance, which is frequently paid in advance for multiple future
periods; an entity initially records this expenditure as a prepaid expense (an asset), and then charges
it to expense over the usage period. Another item commonly found in the prepaid expenses account is
prepaid rent.

Expenditures are recorded as prepaid expenses in order to more closely match their recognition as
expenses with the periods in which they are actually consumed. If a business were to not use the
prepaids concept, their assets would be somewhat understated in the short term, as would their
profits. The prepaids concept is not used under the cash basis of accounting, which is commonly used
by smaller organizations.

Prepayment Accounting

The basic accounting for a prepaid expense follows these steps:

1. Upon the initial recordation of a supplier invoice in the accounting system, verify that the item
meets the company's criteria for a prepaid expense (asset).
2. If the item meets the company's criteria, charge it to the prepaid expenses account. If not,
charge the invoiced amount to expense in the current period.
3. Record the amount of the expenditure in the prepaid expenses reconciliation spreadsheet.
4. At the end of the accounting period, establish the number of periods over which the item will
be amortized, and enter this information in the reconciliation spreadsheet. This entry should
include the straight-line amount of amortization that will be charged in each of the applicable
periods.
5. At the end of the accounting period, create an adjusting entry that amortizes the
predetermined amount to the most relevant expense account.
6. Once all amortizations have been completed, verify that the total in the spreadsheet matches
the total balance in the prepaid expenses account. If not, reconcile the two and adjust as
necessary.
A best practice is to not record smaller expenditures into the prepaid expenses account, since it takes
too much effort to track them over time. Instead, charge these smaller amounts to expense as
incurred. To extend this concept further, consider charging remaining balances to expense once they
have been amortized down to a certain minimum level. Both of these actions should be governed by a
formal accounting policy that states the threshold at which prepaid expenses are to be charged to
expense.

Prepaid Expenses Example

A company pays $60,000 in advance for directors and officers liability insurance for the upcoming
year. The journal entry is:

Debit Credit
Prepaid expenses $60,000
Accounts payable $60,000

At the end of each period, the company amortizes the prepaid expenses account with the following
journal entry, which will charge the entire amount of the prepaid insurance to expense by the end of
the year:

Debit Credit
Insurance expense $5,000
Prepaid expenses $5,000