In this video we're going to walk through the accounting treatment of
prepaid expenses step-by-step.
[Music]
Hey there, welcome back to the channel! I'm James
this is Accounting Stuff and in a few moments we're going to
work through a complete prepaid expense example.
But before we jump in I want to point out that this video
is part of a miniseries that I've created covering
adjusting entries in accounting. Which you can find linked up here
and down below in the description. If you've been having trouble with
prepayments or accruals then I highly recommend you check out these videos.
Especially the first one where I explain the theory behind adjusting entries
and how they all fit into the big picture of accounting.
But in this video we're going to get our hands dirty with a practical example on
prepaid expenses. You'll find out how to
recognise a prepaid expense and then we'll walk through
the adjusting journals for all of the affected accounting periods.
I'm going to be releasing more videos covering deferred revenue,
accrued expenses and accrued revenue.
All of that is coming soon so hit the subscribe button and click on
the bell so you don't miss out on any of those.
Let's go!
But first let's clarify what a prepaid expense actually is.
A prepaid expense is a future expense which has been paid for in advance.
Now what does that mean? It means that we made the payment in a
past accounting period but we don't actually receive the
underlying goods or services until a future accounting period.
Right time for an example… But first I want you to meet someone…
[Music]
This is Betty.
My humble Toyota Yaris. She's not the biggest
and she's certainly not the fastest in fact she's kind of old
but she moves me around from A to B and for that privilege I have to
buy car insurance. Unfortunately I live in Vancouver which
has some of the highest auto insurance premiums in Canada.
Poor Betty who I bought for $3,000 cost me a whopping 2,400 to insure for 2019.
I paid for this in advance on December 15th 2018
and I initially coded the whole payment to insurance expenses.
Question... What monthly adjusting entries
do we need to post to record this transaction in line with the
accrual basis of accounting? We'll begin by taking stock of the facts.
At the end of 2018 we'd already paid for our insurance
coverage for the following year. So this was a future expense
which I had paid for in advance. Does that sound familiar?
Yes. We are dealing with a prepaid expense.
I paid two thousand four hundred dollars in advance on December 15th 2018.
which I coded to the insurance expense account. Now what would that journal entry look like?
Well I paid out $2,400 so my cash balance has to decrease by
two thousand four hundred. Cash is an asset
which is the “A” in “DEALER”. That makes it a normal debit account.
So debits increase it and credits decrease it.
That means that on December 15th I would have credited my cash account by $2,400.
I already said that the other side of the journal went to the insurance expense account.
Well expenses are the “E” in “DEALER” also a normal debit account.
So to increase them, I would have debited the insurance expense
account by $2,400. Here we have the initial journal entry.
When I posted it it would have hit both the
cash account in the balance sheet and the insurance expense account
in the income statement. We can visualise the impact of
this journal entry on the general ledger using T accounts.
In T accounts debits always go on the left
and credits always go on the right. So this is the result of that initial entry
back in December 2018 and it would have been fine if we were
cash accounting because when we cash account
we record expenses once cash is paid out. But the problem is we're accrual accounting.
So expenses should always be recorded as they are incurred
and that means that our expenses at the end of 2018 are overstated by $2,400.
Time for our first adjusting entry. I'm going to show you how to record a
prepaid expense. We're going to need to post this one into
the December 2018 accounting period before it gets closed for good.
Our insurance expense account is overstated by $2,400
so our adjusting journal needs to clear all of this out.
Last time we debited the account so this time we need to credit the insurance expense
account by $2,400. But where does the other side
of this journal entry go? We can’t put it anywhere in the
income statement because that will affect our
profit for the year. That leaves us with one option…
The balance sheet. But where in the balance sheet?
Is a prepaid expense an asset or a liability? Well there's an easy way to check this.
Assets bring us future economic benefit whereas liabilities involve
a future economic sacrifice. In this situation I've already paid
for the car insurance so now it's down to the insurance company to provide
me with coverage for the next 12 months. I'm going to receive the
benefit of that coverage so this prepaid expense should
be recognised as an asset in the balance sheet.
In fact prepaid expenses are always recognised as assets
in the balance sheet. That means the other side
of the journal entry is a debit of two thousand four hundred
to prepaid expenses in the balance sheet. Let's update our T accounts to find out
what impact this journal entry had on the general ledger.
So at the end of 2018 we have negative cash of two thousand four hundred dollars
no insurance expenses in the income statement
and a $2,400 prepaid expense which we're holding as an asset
in the balance sheet. This is exactly where we want to be.
Now when it comes to 2019 we have some more adjusting entries to post.
12 in total one for each month of the year.
So let's bring up a timeline for 2019 and break it down into
twelve accounting periods from January 1st all the way
through to December 31st. In accrual accounting
expenses are recorded as they are incurred so we need to release our prepaid expense
from the balance sheet as we consume or get the benefit from our insurance policy.
In January 2019
I've consumed 1/12 of the insurance coverage. 1/12 of $2,400 is $200
so the insurance expense that we need to recognise in our
income statement is $200 for January 2019. The adjusting journal entry that we need to
post looks like this. We need to debit the insurance expense
account by $200 to increase our expenses in the income statement
and we need to credit prepaid expenses by $200 to decrease our assets
in the balance sheet. So with 11 months of insurance coverage
left on the policy we're carrying $2,200 of prepaid expenses
as an asset in the balance sheet and we've incurred an insurance expense
of $200 in the income statement. This process of releasing prepayments
from the balance sheet needs to continue for the rest of the year.
At the end of May we've consumed five twelfths of our insurance coverage.
So we need to have posted this journal entry 5 times
recognising a $200 insurance expense in the income statement on each occasion.
With seven months of insurance coverage left on our policy we have $1,400 of
prepaid expenses held in the balance sheet and $1,000 of insurance costs
expensed in our income statement. Five months of policy consumed
over a 12-month period which gives us $1,000.
Likewise you could do the same to work out the prepaid expense in the balance sheet.
We have seven months of coverage or future economic benefit left on the policy
so we have prepaid expenses of $2,400 multiplied by seven over 12
which gives us an asset of one thousand four hundred dollars
in the balance sheet. Come December 31st the adjusting entry
we need to post is exactly the same as the ones that we posted
for the previous 11 months. Debit insurance expenses by $200
in the income statement and credit prepaid expenses by $200
in the balance sheet. However this time we've consumed
all of our insurance policy. We are no longer expecting to get
any future economic benefit. So we are no longer holding any
prepaid expenses in the balance sheet.
This asset has been reduced to zero because we have released all of it
to the income statement where we have recorded an insurance expense
of $2,400 for 2019. Our cash account is still showing
a credit for December in the prior year because that's when we paid for the policy.
So we've recorded our expenses as we incurred them
and our books are in line with the accrual basis of accounting.
I'm going to be releasing more videos just like this one for
deferred revenue accrued expenses
and accrued revenue which you'll be able to
find in the adjusting entries playlist over here.
Click on this circle to subscribe so you don't miss out on those
and as always if you've got any questions let me know down below in the comments
or message me directly on instagram @accountingstuff