How to Record a Prepaid Expense

Adjusting Accounts to Match Prepayments to an Accounting Period

Jul 3, 2009 Miranda Miller

Prepayments are those made in advance and used throughout an accounting period, such as rent or insurance. It is important to match these payments to the right period.

Adjusting accounts is the fifth of nine steps in the accounting cycle. Account balances must be brought up to date before preparing an accurate adjusted trial balance, which is used to create financial statements such as the Income Statement and Balance Sheet.

Examples of Prepaid Expenses

A prepaid expense is any payment made to a vendor that pays for a product or service in advance. Rent is a prepaid expense because it is paid at the beginning of a period and used over the course of that accounting period, or perhaps over several periods. If a company pays $12,000 for rent for the year 2010, they must match $1,000 of that payment to each of the 12 months in which it was used.

Another example of a prepaid expense is insurance. Companies often pay the entire yearly premium at once. However, recording the entire payment in one accounting period results in an overstatement of expenses for that period, and an understatement of expenses in each of the other accounting periods in which the expense should have been applied.

How to Record Prepayments

A prepaid account is an asset account. When an amount is paid towards an expense that will be used in later accounting periods, usually within one year, it becomes an asset. As the service is used throughout the year, it becomes an expense.

For example, a company pays $600 in cash for an insurance policy for one year. On January 1st, the transaction is recorded, using double-entry accounting, as a credit to the Cash account (because a credit reduces the balance of an asset account), and a debit to the Prepaid Insurance account (to increase the value of this asset account). The balance of the Prepaid Insurance account is $600.

How to Adjust Prepaid Expense Accounts

On January 31st, the company must adjust the prepaid accounts to reflect that a portion of their balance was used during the January accounting period.

The portion of the balance used in January is 1/12 of the yearly amount, or $50. This amount becomes an expense. The adjusting entry is a credit to the Prepaid Insurance account (to reduce the balance of this asset) and a debit to the Insurance Expense account (to increase the balance of the expense account).

The new Prepaid Insurance account balance is $550, while the new Insurance Expense account for this period is $50. The Prepaid Insurance balance carries over to the beginning of the next accounting period.

The Effects of Failing to Adjust Accounts for a Prepaid Expense

Assuming financial statements were created every month, at the end of the accounting period, expenses would be artificially low and assets artificially high in the months where no expense was recorded to reduce the prepaid account. This affects financial statements by overstating owner's equity.

Businesses need accurate financial statements to make good business decisions. Failing to properly adjust for prepaid expenses also violates the Generally Accepted Accounting Principle of matching transactions to the proper accounting period.

For more information on Generally Accepted Accounting Principles, see the Quick Reference GAAP Guide.

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