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:
|
Debit |
Prepaid Expense (Asset) |
|
|
Credit |
Cash/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:
|
Debit |
Prepaid Rent |
$10,000 |
|
Credit |
Cash/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:
|
Debit |
Rent Expense (Income Statement) |
$10,000 |
|
Credit |
Prepaid Rent |
$10,000 |
Quiz
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Question
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.
Correct.
Prepaid expense for 10 months should be recognized since it relates to the subsequent accounting period and therefore should not form part of the current year's expense.
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.
Incorrect.
No prepayment must be recognized as the payment was made after the year end. Had the payment been made by the scheduled date, the entire amount would have been recognized as a prepaid expense as it relates to the subsequent accounting period.
XYZ LTD paid DEF LTD, an advertising agency, on 1st December 2011 for advertising services rendered in December 2011.
Incorrect.
No prepayment exists at the reporting date (31st December). The prepayment that had arisen on 1st December 2011 has been reversed at the year end as the related expense has already been incurred.