Also known as prepayments, prepaid expenses are costs paid ahead of time, benefiting a company for more than one accounting time period. In business, prepaid expenses are part of a set of adjustments known as deferrals. Accounts usually manage prepayments and other deferrals by adjusting for the expenses at the end of the accounting interval. Rent, insurance, and supplies are all typical prepaid accounts.
The first time the expense is prepaid, the accountant records it as an asset account increase, which represents the prepayment’s future benefit or service. Funds in the asset account expire over time or through use. For example, rent and insurance expire due to the passage of time, while supplies decrease through use. Deducting the daily expiration of these expenses would be tedious and time consuming, which is why accountants usually adjust for prepaid costs when preparing closing accounting statements.
When preparing to close accounts, adjusting entries for prepaid expenses serve two purposes. First, the adjustment shows the amount of funds that expired during the current accounting time period. Second, the adjustment shows the remaining balance of prepaid funds.
Before the adjustment, the prepaid assets are higher than the true balance and expenses are lower. Accountants adjust for this discrepancy by increasing expenses and decreasing assets by the amount expired over the current accounting interval. How the expired amount is calculated depends on several variables, including the length of the time period and the type of prepaid expenses.
Supplies — such as envelopes, paper, and printer cartridges — are recorded as prepaid expenses added to the asset account when acquired. Over the course of operations, the supplies are used, and then inventoried at the close of the accounting interval. The estimated difference in cost of supplies from the beginning to the end of the time period is adjusted as the expired asset and expense.
Insurance, which must be paid in advance, protects a company from financial loss due to theft, fire, or similar events. Accounts record initial insurance prepayments as an increase to assets and then deduct the expense incurred during the accounting interval. The amount deducted depends on the insurance company’s premium for the time period. Accountants record rent expenses in a similar manner.
Unearned revenues are prepayments made to the company by another organization. These are also adjusted for at the end of accounting time periods, but the funds begin as a deduction from assets and are added back as adjustments. These prepaid expenses are worth more as time passes or through use by the prepaying organization.