Sometimes, you pay for business goods and services before you use them. These kinds of purchases require special attention in your books. Do you know how to record prepaid expenses? If not, follow this simple guide to accounting for prepaid expenses to keep your accounting records accurate.
What is a prepaid expense?
Prepaid expenses are when you pay for items that you will receive in the near future. When you pay for something before you receive it, you gain a prepaid expense. Prepaid expenses do not provide value right away. Instead, they provide value over time.
Prepaid expenses expire as you use them. For this reason, you cannot expense the entire value of the item immediately. You must record a prepaid expense in your business financial records and adjust entries as you use the item.
What are prepaid expenses in small business?
Small business owners make many purchases that are considered prepaid expenses. Any time you pay for something before you use it, you need to recognize a prepaid expense in your books.
The following list shows common examples of prepaid expenses:
- Paying rent before using a commercial space
- Small business insurance policies
- Equipment paid for before use
- Some utility bills
- Interest expenses
Is a prepaid expense an asset?
Expense the item over time as you receive its benefits. As you use the item, decrease the value of the asset. The value of the asset is replaced with an actual expense recorded on the income statement. Once the item is used, it is an expense.
Journal entry for prepaid expenses
You record prepaid expenses as assets on the balance sheet at the time of purchase. Record the prepaid expenses journal entry in your books before using the good or service.
To begin posting journal entries for prepaid expenses, first debit an asset account. And, credit the cash account (or whatever account you used to pay). You increase the prepaid expense asset account and reduce the cash balance.
The initial journal entry looks like this:
|Prepaid Expense Asset Account||Debit|
Expenses need to match revenues when an expense contributes to revenue. That way, you recognize the expense when the benefits tie back to revenue.
As you use a prepaid item, remove its value from the asset account on the balance sheet and record it as an expense on the income statement. The expense you record is the amount associated with the accounting period. Each time you record an expense, the asset account gets smaller and the expense account becomes larger.
To record the actual expense, use these journal entries:
|Prepaid Expense Asset Account||Credit|
For example, you prepay six month’s worth of rent, which adds up to $6,000. When you prepay rent, you record the entire $6,000 as an asset on the balance sheet. Each month, you reduce the asset account by the portion you use. You decrease the asset account by $1,000 and record the expense of $1,000.
Once you use the prepaid item, the asset account should be empty, and the expense account should show its full value.
Need a refresher on how debits and credits work in small business accounting? Check out our at-a-glance guide on debits and credits.
Adjustments for prepaid expenses
Adjusting entries help to balance your books. They do not show new business transactions. Instead, they adjust a previously recorded transaction. Use adjusting entries to recognize expenses in the period you incur them.
To recognize prepayment expenses, use adjusting entries. You create an adjusting entry when you debit the actual expense account and credit the prepaid expense asset account. The entry reduces the asset account and increases the expense account.
Repeat the process until the expense is used up. Adjusting entries result in the asset account equaling zero and the expense account equaling the purchase amount.
Examples of prepaid expenses
Prepaid expense journal entries help you keep your accounting books accurate. Let’s look at some examples of prepaid expenses.
Prepaid expense example 1
Let’s say you buy a one-year insurance policy that costs $1,800. You pay upfront and use the insurance throughout the year.
When you buy the insurance, debit the prepaid expense account to show an increase in assets. And, credit the cash account to show the loss of cash.
|Prepaid Expense Asset Account||$1,800|
Each month, adjust the accounts by the amount of the policy you use. Since the policy lasts one year, divide the total cost of $1,800 by 12. Adjust the accounts by $150 each month.
Expense $150 of the insurance with a debit. Reduce the prepaid expense account with a credit. Repeat the process each month until the policy is used and the asset account is empty.
|Prepaid Expense Asset Account||$1,500|
Prepaid expense example 2
You prepay $9,000 of rent for six months. You paid for the space, but you have not used it yet. You need to record the amount as a prepaid expense.
First, debit the prepaid expense account to show an increase in assets. Also, credit the cash account to show the loss of cash.
|Prepaid Expense Asset Account||$9,000|
As each month passes, adjust the accounts by the amount of rent you use. Since the prepayment is for six months, divide the total cost by six. Adjust your accounts by $1,500 each month.
Expense $1,500 of the rent with a debit. Reduce the prepaid expense account with a credit. Repeat the process each month until the rent is used and the asset account is empty.
|Prepaid Expense Asset Account||$1,500|
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