Prepaid Expenses

Prepaid Expenses

Prepaid expenses are the costs that are already paid by an individual or organization, but they are not yet used up or expired. Some companies might decide to pay for their future expenses in advance to protect the space, goods, or an increase in the future price of the product. If the amount expires either by using up the amount or by possessing the product, the current asset account is credited (reduced), and the reduction amount reported as expenses on the income statement (Lessambo, 2018).  The nature of products affect prepaid expenses therefore will always exist; thus, prepaid expenses must be adjusted to certify that they are known in the periods in which they were incurred.

A company signs a one-year lease on a storeroom and purchases insurance for the warehouse on products to be stored on 1^st January 2020. The company pays $48,000 in cash earlier for a 12-month coverage policy for the storeroom and the products in it. Therefore, this transaction needs to be adjusted monthly to fit the annual amount paid. The initial journal entry for the company would be as below.

The company will have to make adjustments every month to fit the prepaid amount and the correct monthly dates. The prepaid insurance account would like the one below, monthly.

The $4,000 monthly amount is arrived at by dividing the lump sum by 12 months, for example, $48,000/12 = $4,000. The adjusting amount of $4,000 is done every end month, and at the end of the year, when the coverage policy has no long-term economic benefits, the prepaid amount would be zero (0).

If the prepaid expenses are not adjusted accordingly, both the income statement and the balance sheet will be impacted. The prepaid expenses for the company will be overstated while the expenses incurred will be understated (Warren & Farmer, 2020). It will, therefore, have adverse effects on the company if they use the accounts to make decisions.