Lesson Objectives:- The definition of prepaid expenses
- How to use adjusting entries for prepaid expenses.
- Real world application
In the last lesson, you learned about the different adjusting entries and how to conduct an adjusting entry. I reviewed an example of an accrued expense and how to record the debit and credit entry. This lesson will continue to the next type of adjusting entries that are performed in the accounting cycle, prepaid expenses.
Prepaid expenses have already been paid for. Payment was issued upfront as opposed to being owed as with an accrued expense. They basically are the polar opposite of the accrued expenses as the money is paid in advance instead of owed. The expenses are paid in cash and recorded as assets prior to being recorded as an adjusting entry.
For prepaid expense adjusting entries, we will need to align the expense to the time frame that we are reporting for. Essentially, we need to show that the expense has been consumed for that particular accounting period. Let's review how prepaid expenses are recorded.
One example would be paying one year of rent for a warehouse space for a total of $42,000 for the year. The company initially paid the contracted amount on April 1st for the entire year. At the end of April, we must record the entry that shows the expense consumed for that month time period. The initial journal entry for the payment would be as shown above.
Now let's look at how the adjusting entry would be prepared at the end of the first month. Since we are using the warehouse space for business operations, this amount would be considered an expense. In this example, the company isn't earning any revenue in this transaction, they are using the property on a rental basis.
When preparing financial statements for the month, we will need the adjusting entry to show that we have expensed one-month worth of rent. To calculate how much one month of rent is equal to, we would simply divide the yearly amount of $42,000 by 12 months. The monthly expense would be $3,500. Therefore, on the adjusting entry below we would record the rent expense as a debit of $3,500 and the prepaid rent as a credit of $3,500.
Other examples of prepaid expenses would be: prepaid insurance or supplies.
We've just recorded the adjusting entry for one-month worth of prepaid expenses. Let's validate how prepaid expense adjusting entries are aligned with the three rules we reviewed in the previous lesson:
1. Prepaid expenses are focused on expenses.
2. The adjusting entry does not involve cash.
3. The passage of time for one month is shown.
If you need a refresher on the different types of adjusting entries or rules for recording them, refer back to the previous lesson. In the next two lessons, we will be reviewing the two types of revenue adjusting entries.