Rent and insurance are often paid in advance for a business.Pre-paid expenses are expenses that are paid in advance.Knowing how to account for pre-paid expenses requires an understanding of some key accounting principles, followed by the recording of a few simple journal entries.
Step 1: You should be familiar with accrual-based accounting.
The basic principle of accrual-based accounting is important in order to understand the accounting for pre-paid expenses.In accrual-based accounting, revenues are reported on the income statement when they are earned, not when cash is received.If you provide a service worth $1,000 in June, but don't get the cash for it until August, your income will be reported on the income statement as $1,000 of revenue.If there were no other revenues from the business, the income statement would show no revenues.You earned the revenues in June.When the cash is provided, not when the revenues are earned, this is different from cash-based accounting.
Step 2: Understand the definition of pre-paid expenses.
A future expense that is paid for in advance is called a pre-paid expense.Typically, it involves an expenditure during one accounting period, followed by the consumption of whatever the pre-payment was for, over multiple periods.Insurance premiums, rent, and any business contracts that require payment in advance are some of the common examples of pre-paid expenses.You can pay your insurance premium six months in advance.Over the course of six months, that premium will be used.
Step 3: Refer to the link between accrual accounting and pre-paid expenses.
The same principle applies to expenses and revenues, as Accrual accounting requires that revenues be recognized in the period for which they are earned.Expenses are not recognized when cash is paid out or when pre-paid expenses are paid for, and are instead used over time.If you pay rent six months in advance, the pre-paid expense won't be recorded in the month when you send the check.The expense would be recorded over the course of six months.For the six month period, one sixth of the total rent amount will appear on the income statement.The treatment of pre-paid expenses is governed by the matching principle.The principle states that expenses should be recorded when the associated goods or services have been used, not when they are paid for, so that they match the revenues that the expense helped to earn.
Step 4: Understand the basics of accounting for pre-paid expenses.
The basic process of accounting for pre-paid expenses involves placing the expense on the balance sheet as an asset when it is paid, and then charging it as a expense over time.If you prepay $12,000 worth of rent on January 1st, it will be placed on the balance sheet as an asset.As time goes on, it would gradually be charged as an expense and the asset balance would be reduced.The asset account would be reduced by $1,000 at the end of January, and the income statement would show a $1,000 increase.Pre-paid expenses are placed on the balance sheet as an asset.The company now has the right to receive good or service, in this case rent.The value of the pre-paid expense makes it an asset.
Step 5: Make the pre-paid expense payment and record the journal entry.
The first step is to pay cash for the pre-paid expense.An entry in the general journal is needed to reflect this activity.Consider a firm that pays $12,000 for a year's worth of insurance on January 1.If you are using accounting software, open it and select the account you want to create.The above entries would add $12,000 to assets, and subtract $12,000 from cash, since prepaid insurance is an asset account.From one asset account to another, the asset balance is unaffected.
Step 6: To expense the asset, record the journal entry.
The portion of the asset that has been used should be expensed to the income statement at the end of each accounting period.The company releases financial statements quarterly.The prepayment insurance needs to be expensed by the end of the first quarter.To record the journal entry, you have to payDebit Insurance Expense and credit Prepaid Insurance.The entry moves the account balance to the income statement as an expense.3 months' worth of insurance coverage is now provided by the insurer and can be recognized as an expense.
Step 7: Expense the asset until the end of its life.
The journal entry should be made at the end of the accounting period.The expense should be recorded on December 31 if the firm uses the year as its accounting period.If the accounting period is quarterly, for the $12,000 pre-payment, each quarter would see $3,000 move from the Prepaid Insurance asset account to the Insurance Expense account.By the end of the fourth quarter, the Prepaid Insurance account would have a balance of zero.The process of accounting for a pre-paid expense ends when the expense is used up over the course of the year.