A business enterprise will have to incur different expenses when undertaking its business activities. Many a times an entity may make advance payments for these expenses which are incurred. Any expense which is paid in advance before receiving the benefit of the payment is called as prepaid expense.

Prepaid expense is an expense paid in advance but which has not yet been incurred. In other words prepaid expenses are the future expenses that have been paid in advance. Examples of prepaid expenses are taxes, salaries, bills, rent, and insurance and so on.

The amount of prepaid expenses that have not yet expired are reported on a company’s Balance Sheet as an asset. As the amount is paid, the asset is reduced and an expense is recorded for the amount of the reduction. Hence, the balance sheet reports the unexpired costs and the income statement reports the expired costs.

 

Following accounting entry is required to account for the prepaid expense:

At the time of Payment:

Prepaid Expense A/c               Dr

To Cash/Bank A/c

At the time of year-end adjustment:

Expense A/c                            Dr

To Prepaid Expense

 

 

Let us understand with an example:

ABC Company paid Office Rentals worth AED 60,000/- for the period 1st April, 2016 to 31st March, 2017 on 7th April, 2016.

 

For the Financial Year ending 31st December, 2016, office is going to be occupied for 9 Months and the rental for that period comes to (60,000*9/12) = AED 45,000/-

Hence the total excess amount paid comes to AED 15,000/- (60,000-45,000). This excess amount is called prepaid expense.

So, the accounting entries will be as follows:

 At the time of Payment:

Prepaid Rent A/c                     Dr                    60,000

To Bank A/c                                                                               60,000

 

At the time of year-end adjustment:

Rent A/c                                  Dr                    45,000

To Prepaid Rent A/c                                                                        45,000