Prepaid Expense


Prepaid expense is expense paid in advance but which has not yet been incurred.

Expense must be recorded in the accounting period in which it is incurred. Therefore, prepaid expense must be not be shown as expense in the accounting period in which it is paid but instead it must be presented as such in the subsequent accounting periods in which the services in respect of the prepaid expense have been performed.

Entity should therefore recognize an asset in respect of expense it has paid in advance until such time as the services that are due in relation to the prepaid expense have been performed by the suppliers/contractors. Following accounting entry is required to account for the prepaid expense:

DebitPrepaid Expense (Asset)
CreditCash/Bank

Example

ABC LTD pays advance rent to its landowner of $10,000 on 31st December 2010 in respect of office rent for the following year. ABC LTD has an accounting year end of 31st December 2010.

ABC LTD will recognize an asset of $10,000 in the financial statements of year 2010 in respect of the prepaid expense to recognize its right to use office space in the following year. Following accounting entry will be recorded in the books of ABC LTD in the year 2010:


DebitPrepaid Rent$10,000
CreditCash/Bank$10,000

The prepaid expense will be recognized as expense in the next accounting period to which the rental expense relates. Following accounting entry will be recorded in the year 2011:

DebitRent Expense (Income Statement)$10,000
CreditPrepaid Rent$10,000

Test Your Understanding

XYZ LTD has a year end of 31st December 2011. Which of the following transactions should lead to recognition of prepaid expense in the financial statements of XYZ LTD?

XYZ LTD paid rent in advance for one year on 1st November 2011.

XYZ LTD entered into an insurance contract for 12 months starting from 1st January 2012. Payment was scheduled to be made in advance by no later than 25th December 2011. However, the payment was actually made on 1st January 2012.

XYZ LTD paid DEF LTD, an advertising agency, on 1st December 2011 for advertising services rendered in December 2011.