How to Adjust the Accounting for Prepaid Expenses
Companies may pay for certain services ahead of time. In other words, the cash payment for services or goods occurs in a different accounting period from the period in which the company incurs these expenses. Prepaid expenses include service contracts, memberships in trade groups, leases and office supplies. The prepaid expense account is in the current assets section of the balance sheet. At the end of an accounting period, companies make adjusting entries to reflect the portion of prepaid expenses that it incurred during the period.
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Instructions
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Record an advance payment in the prepaid expense asset account. The accounting entries are to debit (increase) prepaid expense and credit (decrease) cash. Note that the name of the account might be something other than prepaid expense; a company may record its business insurance premium payment as prepaid insurance or its lump sum rent payment as prepaid rent. For example, if a company buys a $1,200 annual maintenance contract from an equipment servicing company, the accounting entries are to debit (increase) prepaid expense and credit (decrease) cash by $1,200 each.
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Calculate the incurred expense at the end of an accounting period, which is equal to the product of the monthly expense rate and the number of months in the period. Continuing with the maintenance fee example, the monthly expense rate is $100 ($1,200/12). Therefore, if the company paid the fee on Jan. 1, it has incurred three months of maintenance expense by March 31 when it closes its books for the quarter and prepares its financial statements. The incurred expense amount is $300 ($100 x 3).
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Adjust the prepaid expense account at the end of an accounting period to reflect the incurred expenses during the period. The accounting entries are to debit (increase) the appropriate income statement expense account and credit (decrease) the prepaid expense account. In other words, move the incurred expense amount out of the asset account and into the operating expenses section of the income statement. Continuing with the example, the accounting entries are to debit (increase) maintenance expense and credit (decrease) prepaid expense by $300.
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Tips & Warnings
The prepaid expenses for one company may represent unearned revenues for another. Unearned revenue means that a company has received payment but has not delivered goods or provided services.
