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What is prepaid expenses in accounting?

Recently, we have been learning about year end accruals and adjustments. I missed a class however and so I am heaps behind and my friends don't want to be useful and help me out!! :/

Please can someone be so kind as to explain what a prepaid expense is??? haha

Much appreciated! :P
Posted in Accounting, asked by lefe, 4 years ago. 1024 hits.

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A prepaid expense is exactly what it says it is - an expense that has been "prepaid" or "paid in advance".

An example of this could be a rent payment. Say for instance you lease some office space. The lessor (the owner of the building) would draw up a contract with you stating the amount of rent to be paid per month. The contract would usually require the rent to be paid at the beginning of the month. So on 1 July, you would pay the rent for the month of July. You could then use the office space for the full month of July. On 1 July, you would have a prepaid expense which would then be "used up" over the month.

Amounts that are prepaid on a monthly basis don't usually have any bearing on accounting and financial reporting. So in the above example, you wouldn't need to recognise a prepaid expense in the business accounts. When amounts have been prepaid for more than one month and they cover a period that overlaps with the end of the financial year, then we have to make an adjustment in the accounting records.

Remember that 30 June is the financial year end. This is when we prepare the Income Statement and Balance Sheet with relevant adjustments.

Have a look at the following example:
Quarterly insurance premium paid in advance on 1 May 2012 for the amount of $345.

A quarter of a year is 3 months, therefore the premium paid covers the months of May, June and July. Two of those months (May and June) are before year end, while July is after year end and therefore is part of next year's accounts. At the end of the year, we therefore have one month of prepaid insurance (345 / 3 = 115).

The journal is as follows:

Dr Insurance Expense (exp) 345
Cr Cash at Bank (asset) 345

Dr Prepaid Insurance (asset) 115
Cr Insurance Expense (exp) 115

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4 years ago
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