Expenses that are purchased and paid for in advance are classified as prepaid expenses. For example, a horse stable may purchase fire insurance to protect the business from unforeseen occurrences. The following will show how to account for a fire insurance payment as a prepaid expense.
Your fire insurance bill is due on May 15 for insurance coverage from May 15 to Nov 15, a future coverage period. Payments made for future periods are considered paid in advance or prepaid. This prepaid expense is an asset of your business until the time lapses. As time lapses, this asset becomes an expense.
On May 15 you send in a $600 payment to your fire insurance company.
When recording any type of transaction, balance is the key. What is recorded in one account must equal what is recorded in another account. To which accountants refer to as debits must equal credits (more detail about debits and credits in future blogs).
To record your $600 fire insurance payment you will need to record $600 in 2 accounts.
1) Prepaid Expense – Add (Debit) $600 to the balance in this account.
2) Cash – Subtract (Credit) $600 from the balance in this account.
Quiz time!
Q – Do debits equal credits?
A – Yes! If debits + credits = 0, then we are in balance. Another way to tell is if your accountant smiles!
Visually, this transaction looks like this –
|
Account |
Debit |
Credit |
|
Prepaid Insurance |
$600 |
|
|
Cash |
|
$600 |
|
Totals |
$600 |
$600 |
On June 15, 1 month (1/6 of 6 month coverage) of coverage has lapsed. This is the part where you would start changing your asset (prepaid expense) into an expense. Doing this moves the lapsed amount from one account to another, a reclassification.
Since only 1 month of coverage has lapsed, we only record $100 which is 1/6 of $600.
1) Insurance Expense – Add (Debit) $100 to the balance in this account.
2) Prepaid Insurance – Subtract (Credit) $100 from the balance in this account.
|
Account |
Debit |
Credit |
|
Insurance Expense |
$100 |
|
|
Prepaid Insurance |
|
$100 |
|
Totals |
$100 |
$100 |
As part of recording monthly transactions, you would repeat this step every month for the remainder of the coverage period.
Summary
A prepaid expense is an asset which changes to an expense as the coverage period lapses.
If Debits = Credits, you are in balance!