Understanding Prepaid Expenses: Examples & Journal Entry

Harold Averkamp (CPA, MBA) has worked as a university accounting instructor, accountant, and consultant for more than 25 years. Stay up to date on the latest corporate and high-level product developments at BlackLine. Go beyond with end-to-end transformation.Powerful technology is only part of the story. Successful transformation requires expert guidance from a trusted partner. Explore offerings that unlock new transformation opportunities and make transformation a reality. Finance and IT leaders share a common goal of equipping their organizations with ways to work smarter to enable competitive advantage.

In this way, they contribute to the calculation of the current ratio but they are excluded from the list of liquid assets. Assets that are generally expected to be used, sold, or depleted within the current accounting year (usually 12 months) are called current assets. When the insurance premium is due, the amount due is deducted from the prepaid account and is shown as an operating expense in the Profit and Loss A/c prepared for the current period. Prepaid insurance is also considered an asset because of its redeemable value. Any remaining prepaid portion of the premium could be redeemed or refunded to the business if the business cancels the policy before the period covered by those premiums has expired.

Autonomous Accounting

From the perspective of a business, the initial transaction of cash to a prepaid account is a debit expense between two current accounts. As these accounts are both asset accounts, they do not increase or decrease any value on the balance sheet. Overall, prepaid expenses are an important accounting concept that helps businesses to better manage their cash flow and accurately reflect the value of goods and services received over time.

Upon signing the one-year lease agreement for the warehouse, the company also purchases insurance for the warehouse. The company pays $24,000 in cash upfront prepaid insurance journal entry for a 12-month insurance policy for the warehouse. The most important calculation regarding prepaid insurance reflects the unexpired portion of the policy.

What Kind of Account Are Prepaid Expenses?

In the meantime, an amortisation schedule corresponding to the actual realisation of the prepaid expenses or the benefits of the prepaid asset will be created as well. If the premium were $1,200 per year, for instance, you would record the check for $1,200 as a credit to the cash account in your journal, decreasing the value of that account. Then you would enter a debit of $1,200 to the prepaid insurance asset account, increasing its value. Prepaid insurance is considered a business asset, and is listed as an asset account on the left side of the balance sheet. The payment of the insurance expense is similar to money in the bank, and the money will be withdrawn from the account as the insurance is “used up” each month or each accounting period.

Prepaid expenses are recorded as an asset on a company’s balance sheet because they represent future economic benefits. Unexpired or prepaid expenses are the expenses for which payments have been made, but full benefits or services have yet to be received during that period. Prepaid expenses usually provide value to a company over an extended period of time, such as insurance or prepaid rent.

How Are Prepaid Expenses Recorded in a Company’s Financial Statements?

On January 1, Superpower Inc, paid $3,000 for a one year insurance policy. 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. Before diving into the wonderful world of journal entries, you need to understand how each main account is affected by debits and credits. When a salary is paid in advance to an employee but the employee is yet to work for that period it is called salary paid in advance.

• One popular example of a prepaid expense would be insurance because it always has to be paid early.
• Moving forward, this prepaid rent will be utilised in the future to lower the rent expense as it gets incurred.
• Hence, the printer ought to be noted down as an expense over the period in which its benefit has been fully realised.
• As previously explained, prepaid expenses are to be recorded as a type of current asset on the firm’s balance sheet.
• For example, the purpose of insurance is to buy proactive protection for the future.
• Prepaid expenses are recognised as a type of asset because they represent products and services whose benefits will only be incurred at a later date.