Introduction to Adjusting Journal Entries and Prepaid Expenses Video Tutorial & Practice

Accumulated Depreciation – Equipment is a contra asset account and its preliminary balance of $7,500 is the amount of depreciation actually entered into the account since the Equipment was acquired. Therefore the account Accumulated Depreciation – Equipment will need to have an ending balance of $9,000. The income statement account that is pertinent to this adjusting entry and which will be debited for $1,500 is Depreciation Expense – Equipment. Notice that the ending balance in the asset Supplies is now $725—the correct amount of supplies that the company actually has on hand. The income statement account Supplies Expense has been increased by the $375 adjusting entry. It is assumed that the decrease in the supplies on hand means that the supplies have been used during the current accounting period.

That is $30,000/12 to arrive at the $2,500 adjusting entry for prepaid insurance that will be made monthly. The journal entry for prepaid insurance is a debit to the prepaid insurance account and a credit to the cash account or the company’s bank account. This journal entry records the transaction concerning the purchase of insurance premiums by a company within a specified accounting cycle.

What Are Prepaid Expenses?

Since the prepayment is for six months, divide the total cost by six ($9,000 / 6). When you buy the insurance, debit the Prepaid Expense account to show an increase in assets. The value of the asset is then replaced with an actual expense recorded on the income statement. In small business, there are a number of purchases you may make that are considered prepaid expenses.

  • Rather, they provide value over time; generally over multiple accounting periods.
  • The account in question is debited to record the related journal entry.
  • Prepaid expenses are initially recorded as assets, but their value is expensed over time onto the income statement.

The balance in Accounts Receivable also increases if the sale was on credit (as opposed to a cash sale). However, Accounts Receivable will decrease whenever a customer pays some of the amount owed to the company. Therefore the balance in Accounts Receivable might be approximately the amount of one month’s sales, if the company allows customers to pay their invoices in 30 days. Prepaid insurance is adjusted from time to time to account for the gradual expiration of the insurance premium that had been previously prepaid for by a company.

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How to record a prepaid expense: Examples

You know that before you do that, you need to make sure that all the account balances are correct. When you check the Prepaid Insurance account, the balance on the account is $928. Six months have passed since you have paid for the business liability insurance on June 1st. And it reports accumulated depreciation in the balance sheet as a deduction from the related asset. When the cash is paid, an adjusting entry is made to remove the account payable that was recorded together with the accrued expense previously. Prepaid expenses are payments made in advance for goods or services that will be received or used in the future.

prepaid insurance definition

They are an advance payment for the business and therefore treated as an asset. The accounting rule applied is to debit the increase in assets” and “credit the decrease in expense” (modern rules of accounting). If we subtract this amount from the initial payment for the whole year, we should get a $696 balance on the Prepaid Insurance account. It turns out that you have forgotten to make adjusting entries for the past two months. An adjusting journal entry is usually made at the end of an accounting period to recognize an income or expense in the period that it is incurred. It is a result of accrual accounting and follows the matching and revenue recognition principles.

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In this case, it needs to account for prepaid insurance by properly making journal entries in order to avoid errors that could lead to misstatement on both balance sheet and income statement. Prepaid insurance can be paid monthly, quarterly, or yearly depending on the insurance plan and policies as well as the company’s preference. The prepayment will hence, provide insurance coverage for the company within the period covered by the prepayment. Generally, companies make prepayments for insurance for buildings, equipment, machinery, vehicles, and other valuable items. Once the journal entry for prepaid expenses has been posted they are then arranged appropriately in the final accounts.

Taking into account the estimates for non-cash items, a company can better track all of its revenues and expenses, and the financial statements reflect a more accurate financial picture of the company. Of the total six-month insurance amounting to $6,000 ($1,000 per month), the insurance for 4 months has already expired. In the entry above, we are actually transferring $4,000 from the asset to the expense account (i.e., from Prepaid Insurance to Insurance Expense). Now, let’s assume it is the end of the year, and you need to prepare all the financial reports.

Repeat the process each month until the policy is used and the asset account is empty. As a reminder, the main types of accounts are assets, expenses, liabilities, equity, and revenue. As prepaid insurance is an asset that will expire through the passage of time, the cost of expiration will need to be recognized as an expense during the period. This adjusting entry is necessary for the company to not overstate its total assets as well as to not understate its total expenses during the period.

At the end of the accounting year, the ending balances in the balance sheet accounts (assets and liabilities) will carry forward to the next accounting year. Each month, an adjusting entry will be made to expense $10,000 (1/12 of the prepaid amount) to the income statement through a credit to prepaid insurance and a debit to insurance expense. In the twelfth month, the final $10,000 will be fully expensed and the prepaid account will be zero.

According to the three types of accounts in accounting “prepaid expense” is a personal account. An accrued expense is an expense that has been incurred (goods or services have been consumed) before the cash payment has been made. Examples include utility bills, salaries and taxes, which are usually charged in a later period after they have been incurred. Although Mr. John’s trial balance does not disclose it, there is a current asset of $3,200 on 31 December 2019. Thus, what has been paid for remains an asset unless it is fully used. First, debit the Prepaid Expense account to show an increase in assets.

It reports the remaining amount of the prepaid expense,  $ 2,200, as an asset on the balance sheet. The  $ 2,200 prepaid expense represents 11 months of insurance protection that remains as a future benefit. Prepaid insurance is an asset account on the balance sheet, in which its normal balance is on the debit side.

It is possible for one or both of the accounts to have preliminary balances. Because Allowance for Doubtful Accounts is a balance sheet account, its ending balance will carry forward to the next accounting year. Because Bad Debts Expense is an income statement account, its balance will not carry forward to the next year. Bad Debts Expense will start the next accounting year with a zero balance. What we are actually doing here is making sure that the incurred (used/expired) portion is treated as expense and the unused part is in assets. The adjusting entry will always depend upon the method used when the initial entry was made.

The “Service Supplies Expense” is an expense account while “Service Supplies” is an asset. After making the entry, the balance of the unused Service Supplies is now at $600 ($1,500 debit and $900 credit). In preparing the adjusting entry, our goal is to transfer the used part from the asset initially recorded into expense – for us to arrive at the proper balances shown in the illustration above.

If the premium were $1,200 per year, you would enter a credit of $100 to the prepaid insurance asset account, decreasing its value. Then you would enter a debit to the insurance expense account, increasing the value of the expenses. You would initially debit the Prepaid Insurance account for $2,400 and credit the Cash account for $2,400. After one month, you will types of budgets have used up one month of your insurance policy and only have 11 months remaining on the policy. Thus, you record an adjusting journal entry at the end of the first month by debit Insurance Expense for $200 and crediting the Prepaid Insurance account for $200. You would then make this same adjusting journal entry at the end of each month until the policy expires.

Take note that the amount has not yet been incurred, thus it is proper to record it as an asset. Obotu has 2+years of professional experience in the business and finance sector. Her expertise lies in marketing, economics, finance, biology, and literature. She enjoys writing in these fields to educate and share her wealth of knowledge and experience. For multiple-choice and true/false questions, simply press or click on what you think is the correct answer.

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