How To Allocate Prepaid Expenses For Your Business

The estimated useful life of an asset is the estimated time that a company can use the asset. Useful life is an estimate, not an exact measurement, that a company must make in advance. However, sometimes the useful life is determined by company policy (e.g. keep a fleet of automobiles for three years). Doing so records the incurring of the expense for the period and reduces the prepaid asset by the corresponding amount. The journal entry above shows how the first expense for January is recorded.

Prepaid expenses recorded under the accrual accounting method would be included in the income statement only to the extent that the prepayment benefits the current reporting period. For example, a full year’s worth of rent is paid in advance on January 1. By making this journal entry, the company will be able to record the insurance expense which has been incurred already and the part of prepaid insurance which has now already expired. When there is a payment that represents a prepayment of an expense, a prepaid account, such as Prepaid Insurance, is debited and the cash account is credited. This records the prepayment as an asset on the company’s balance sheet. An amortization schedule that corresponds to the actual incurring of the prepaid expenses or the consumption schedule for the prepaid asset is also established.

Get clear, concise answers to common business and software questions. Contact us to learn more about prepaid insurance prepaid insurance journal entry and if it’s right for you. Prepaids are tracked in the accrual method of accounting, but not the cash method.

A prepaid expense by definition is an expense that has been paid for by the business in advance, that is, before the services for that expense have been availed. In this case, the business must record such expenses as prepaid expenses. As the business begins to use the service, the expense begins to accrue, and the prepaid amount gets deducted accordingly. As the prepaid expense expires in a given accounting period, accountants record a journal entry for the expiration as an expense.

Journal Entry For Recording A Prepaid Expense

If the service or product covers several periods, then the expense will be allocated out throughout each period the benefit is realized. This means that typically the initial entry denoting the prepaid expense will not affect a company’s financial statements because the service or product has not been received. As the benefit of the expense is experienced, the asset account is expensed and reduced. At the end adjusting entries of each accounting period, the portion of the prepaid asset that has been used should be expensed to the income statement. In the example above, assume that the company releases financial statements quarterly.On March 31, the end of the first quarter, a fourth of the prepaid insurance needs to be expensed. To record the journal entry, debit Insurance Expense for $3,000 and credit Prepaid Insurance for $3,000.

As the benefits of the expenses are recognized, the related asset account is decreased and expensed. In conclusion, accounting for amortization is very important to recognize expenses appropriately when they incur. This is also in line with the matching principle where the expenses should be recognize in period in incur in order to generate revenue. Practical Amortization Schedule of Prepaid ExpensesWhen we have such schedule, each month we can record the amortization expenses in one transaction together. This way, it will save your time as you will not need to record one by one as per the example above.

Journal Entries For Prepaid Expenses

This means that even though the expense has been paid upfront, it is not considered an expense yet in a business’s financial records. In other words, these expenses will not be recognized as such until a later accounting period. You pay the up-front insurance premium for the officers’ and directors’ policy of $1,200.

This allocation is represented as a prepayment in a current account on the balance sheet of the company. At the end of the calendar year – December 31, 20X0 – the company will have $8,000 (4 months x $2,000 monthly expense) left as unused prepaid insurance expense. Considering this, the company will need to adjust its prepaid insurance balance of $24,000 to make it $8,000, and the difference ($16,000) will be recorded as insurance expense for the year. This starts with determining if the amount should be expensed over multiple accounting periods, how much should be expensed each period, and for how long.

Advance payments are recorded as a prepaid expense in accrual accounting for the entity issuing the advance. As these assets are used they are expended and recorded on the income statement for the period in which they are incurred. Prepaid insurance is a credit to the insurance company at the time that it is made. In the previous example, the premium that is received for six months of car insurance coverage is initially recorded as a credit. Then there is a monthly debit for each month in the term until the credit is zero.

Examples Of Prepaid Expenses

For these types of insurance, premiums can usually be paid on a monthly, semiannual or annual basis, where the insured pays the premium in advance of the upcoming period of coverage. Prepaid expenses in one company’s accounting records are often—but not always—unearned revenues in another company’s accounting records. Office supplies provide an example of a prepaid expense that does not appear on another company’s books as unearned revenue. The entry above reduces the account balance of Prepaid Insurance, and moves that balance to the income statement as an expense. This is because 3 months’ worth of the insurance coverage has now been provided by the insurer and can be recognized as an expense.

This is often the case for health, life, hazard, automotive, liability and other forms of coverage required by a business. The company can record the prepaid insurance with the journal entry of debiting the prepaid insurance account and crediting the cash account. Then, when the expense is incurred, the prepaid expense account is reduced by the amount of the expense and the expense is recognized on the company’s income statement in the period when it was incurred. When the insurance coverage comes into effect, it is moved from an asset and charged to the expense side of the company’s balance sheet. In this case, the company’s balance sheet may show corresponding charges recorded as expenses.

Chapter 3: Completion Of The Accounting Cycle

These expenses that are paid for in advance are known as pre-paid expenses. Knowing how to account for pre-paid expenses involves firstly an understanding of some key accounting principles, followed by the recording of a few simple journal entries. 31Supplies Expense7,000Supplies7,000To record supplies expense.Before this adjusting entry was made, the supplies asset account had a balance of $8,500.

Many medical professionals also carry malpractice insurance that must be paid in advance. In most cases, the doctor or other medical professional pays for a year of coverage up front with a single payment. Many corporations also carry liability insurance to cover them if they inadvertently bring CARES Act harm to people or property. Accounting records that do not include adjusting entries to show the expiration or consumption of prepaid expenses overstate assets and net income and understate expenses. Sometimes the companies pay for the expenses in advance before the expenses become due.

Accounting Principles I

For example, if you pay $6,000 for your company’s insurance premium for six months, note this payment in your prepaid insurance account . Prepaid expenses may need to be adjusted at the end of the accounting period. The adjusting entry for prepaid expense depends upon the journal entry made when it was initially recorded. AccountDebitCreditPrepaid insurance000Cash000Prepaid insurance and cash are both balance sheet items. Hence, prepaid insurance journal entry does not affect the total assets because it increases one asset account and decreases another asset account at the same amount.

• Companies record expired insurance periodically based on the intersection of their accounting periods and the time structure of the insurance.
• Expenses are recognized when they are incurred regardless of when paid.
• When the company makes an advance payment for insurance, it can make prepaid insurance journal entry by debiting prepaid insurance account and crediting cash account.
• For example, 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.
• You should record expense for insurance each month as you “use up” the policy.
• She is a graduate of Bryn Mawr College (A.B., history) and has an MFA in creative nonfiction from Bennington College.

To post revenue that is deferred to the next period, you would create a short term liability “Deferred Revenue”. So the deposit shown in green on the transaction journal would be coded to Deferred Revenue. Deposits received for a future event are not an asset but a liability. You have unearned revenue, an obligation to perform something in the future. As an example, the entity receives 1000 as a deposit for an event in 2021. You would expect to see on the transaction journal 1000 in green and 400 in black.

Higginbotham Insurance Group

While the concepts discussed herein are intended to help business owners understand general accounting concepts, always speak with a CPA regarding your particular financial situation. The answer to certain tax and accounting issues is often highly dependent on the fact situation presented and your overall financial status. For example, because of recent legal issues, Jill puts her attorney on retainer. Though she pays the retainer in full, Jill still needs to determine how much she will need to expense each month as the retainer is used.

How Do I Record An Advance Payment?

But if you pay your rent for the entire upcoming year, that is a prepaid expense and needs to be recorded as one. In preparing the adjusting entry, our goal is to transfer the used part from the asset initially recorded into expense – for us to arrive at the proper balances shown in the illustration above. Prepaid expenses are future expenses that are paid in advance and hence recognized initially as an asset. Repeat the process each month until the rent is used and the asset account is empty. As a reminder, the main types of accounts are assets, expenses, liabilities, equity, and revenue.

Author: Kevin Roose