As the name implies, Prepaid Expenses represent a prepayment for a future expense.
They are classified as Assets in a company balance sheet since they relate to expenditures which have some future economic benefit to the company.
Typically, Prepaid Expenses which will expire within one year from the balance sheet date are listed in the current assets section of the Balance Sheet.
As the prepaid expense expires in a given accounting period, accountants record a journal entry for the expiration as an expense.
On January 1, Superpower Inc, paid $3,000 for a one year insurance policy.
The transaction causes an increase in an asset (Prepaid Insurance) and a reduction in another asset (Cash).
The Journal Entry would be
Jan 1. Prepaid Insurance Debit $3,000
Cash Credit $3,000
At the end of Jan, one of the twelve months paid for the insurance have expired. So, an entry needs to be made to reduce the prepaid Insurance amount. The amount to be reduced is $250 ($3,000/12) and the entry is
Jan 31st Insurance Expense Debit $250
Prepaid Insurance Credit $250
The Insurance Expense would now be shown in the income statement for January and Balance Sheet prepared for Jan 31st would show the Prepaid Insurance amount or $2,750.
As the insurance coverage expires over multiple future periods, a series of subsequent entries such as the one above are made.
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