Prepaid expenses are costs paid in advance that benefit a business over multiple accounting periods. They are managed through adjustments known as deferrals, with rent, insurance, and supplies being typical examples. Accountants adjust for prepaid costs when preparing closing financial statements, increasing expenses and decreasing assets by the amount due during the current accounting interval. Unearned income is also adjusted at the end of accounting periods, with the funds starting out as a deduction from assets and being added back as adjustments.
Also known as prepaid, prepaid expenses are costs paid in advance, which benefit a business over more than one accounting period. In business, prepaid expenses are part of a set of adjustments known as deferrals. Accounts typically manage prepayments and other deferrals by adjusting expenses at the end of the accounting interval. Rent, insurance, and supplies are typical prepaid bills.
The first time the expense is prepaid, the accountant records it as an increase in the asset account, which represents the future benefit or service of the prepayment. Funds in the asset account expire over time or through use. For example, rent and insurance expire due to the passage of time, while supplies dwindle with use. Deducting the daily due date for these expenses would be tedious and time consuming, so accountants typically adjust for prepaid costs when preparing closing financial statements.
When preparing to close accounts, adjusting entries for prepaid expenses serves two purposes. First, the adjustment shows the amount of funds that were due during the current accounting period. Second, the setting shows the remaining balance of the prepaid funds.
Before adjustment, prepaid assets are higher than the actual balance and expenses are lower. Accountants adjust for this discrepancy by increasing expenses and decreasing assets by the amount due during the current accounting interval. How the past due amount is calculated depends on several variables, including the length of the time period and the type of prepaid expenses.
Supplies, such as envelopes, paper, and printer cartridges, are recorded as prepaid expenses added to the asset account when they are purchased. In the course of operations, supplies are used and then inventoried at the close of the accounting interval. The estimated difference in the cost of supplies from the beginning to the end of the time period is adjusted as the past-due asset and expense.
Insurance, which must be paid for in advance, protects a company from financial loss due to theft, fire, or similar events. The accounts record initial advance insurance payments as an increase in assets and then deduct expenses incurred during the accounting interval. The amount deducted depends on the insurance company’s premium for the time period. Accountants record rental expenses in a similar way.
Unearned income is advance payments made to the business by another organization. These are also adjusted at the end of accounting periods, but the funds start out as a deduction from assets and are added back as adjustments. These prepaid expenses are worth more as time goes on or through use by the prepaid organization.
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