What is prepaid expense?
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Prepaid expense are future expenses that have been paid in advance and its benefits are yet to be received . A prepaid expenses arises when the amount is paid in advance for the goods or services to be received in future. Hence prepaid expenses are treated as an asset of the organisation and its value written down as expense or charged to profit and loss account; after getting its benefits either monthly or yearly.
Certain expenses like insurance premium,rent rates etc, are often paid in advance.In this case a part of the amount paid during a given period relates to a subsequent period .For example the debit in the following expense account shows the premium cost of two-year fire insurance policy.
In this case,We paid 12 months insurance premium, out of this 12 months , premium of three months( 5000/12 x 3 = 1250) are related to current year that is for Financial Year 2015-16 and remaining 9 months premium (5000/12 x 9=3750) is related to up coming Financial Year,That is for 2016-17.
Before the books are closed at the end of 2015, the unexpired premium should be taken out of the expense account and transferred to a prepaid expense or asset account.This is accomplished by the following journal entry.
After this entry is posted,the two accounts affected will appear as follows.
The balance in this account now shows the insurance expenses for 2015 and is debited to the profit and loss account.
Prepaid Insurance account is an asset account;it represents the cost of a valuable right to collect from an insurance company in the event of a fire loss during 2016.So 3750 will be shown on the asset side of the balance sheet as on 31-03-2015.
Prepaid asset will be charged to the expense of the next year. In above case the prepaid insurance will charge to the Insurance A/c as expense and the prepaid Insurance A/c which was carried forward from last Financial year will be cancelled.
After this entry posted to the next year ledger, The insurance account carries a balance of 3750 which is the current year expense chargeable to the revenue /profit and loss account.
And the prepaid insurance account will closed after charging expense from prepaid expense account.Hence it is removed from 2016-17 balance sheet.
Difference between expense and prepaid expense
- Expense are any amount paid for the service or goods received where as prepaid expenses are the amount paid for the goods and services to be received in the future.
- Expenses are charged immediately to the revenue account where as prepaid expenses are expensed only after its benefits received.