Prepaid Expenses are the prepayments that an entity makes to third parties on account of services or goods to be received in some future date within the next 12 months. It is also called Prepayments. An entity cannot record the prepaid expense as an asset in the income statement because the matching principle prohibits that.
Initially, it is recorded in the current assets of the entity and when this item is actually consumed for the relevant expense, it is recorded expense in the income statement. This can be done by passing an adjusting and preparing an adjusted trial balance.
Prepaid Expenses Examples
- Prepaid rent
- Prepaid utilities bills
- Prepaid internet expense
- Prepaid insurance
Journal Entries
When an entity pays for a future expense item, it records the transaction as follows:
| Description | Debit | Credit |
| Prepaid expenses | xxx | |
| Cash | xxx |
Once the expense in actually incurred, it will pass the following entry:
| Description | Debit | Credit |
| Prepaid expenses | xxx | |
| Cash | xxx |
Example
ABC pays $18,000 for the license fee for three years on 1st January, 2015. Record the above transaction in the general journal and how this transaction will apear in the accounts on 31st December, 2015.
Answer/ Solution
| Date | Description | Debit | Credit |
| 01 Jan | Prepaid expenses | 18,000 | |
| Cash | 18,000 | ||
| 31 Dec | License Fee Expense | 6,000 | |
| Prepaid expenses | 6,000 |
The balance sheet on 31st December, 2015 will reflect $6,000 as prepaid expenses in the current assets section and $6,000 as long term in the non-current assets section of the balance sheet.