Prepayments (also known as deferred expense) are assets that represents cash paid in advance for goods or services to be received later. A prepayment is related to unearned income in a sense that one company’s prepayment is other company’s unearned income.
The reason for deferral of expense is the accrual concept of accounting, which requires that an expense must be recognized in the period to which it relates rather than in the period in which it is paid for. Since prepayments are often made for goods or services, the receipt of which spans over two or more accounting periods, prepayments must not be simply expensed on payment date.
Prepayments are usually current assets but in extremely rare cases they may span over 12 months after year end, in which case they are classified as non-current assets.
Accounting for prepayments involves the following journal entries:
- A prepayment transaction is recorded initially by debiting an asset account (such as prepaid insurance, prepaid rent etc.) and crediting cash or bank.
- At the end of each accounting period an adjusting entry is passed that debits expense and credits prepaid asset for the part of goods or services which have been received in that period.
On April 1, 20X5, Company β pays $40,00 for twelve month insurance in advance. Company β’s financial year ends on June 30, 20X5.
(1) Journal entries to account for the above transaction on April 1, 20X5 and June 30, 20X5.
(2) Balance in prepaid insurance account on June 30, 20X5.
April 1, 20X5: To record the prepayment as a current asset:
June 30, 20X5: To record insurance expense for three months [=40000×3/12].
Balance in Prepaid Subscriptions on June 30, 20X5: $400 – $100 = $300