Prepaid Expense

Key Concepts

Based on the accrual basis of accounting, expenses are recorded when they are incurred — when the goods or services have been used — regardless of when cash is paid.

Prepaid expense arises when a business pays for a service in advance but has not yet used it by the end of the financial period. Examples include insurance premiums and rent paid in advance.

Prepaid expense is a current asset — it represents a future benefit that the business has already paid for.

The account name follows the type of expense — Prepaid [Specific Expense] (e.g., Prepaid salaries expense, Prepaid insurance expense, Prepaid rent expense).

How to Remember

Prepaid expense = paid but not yet used = current asset.

• Year-end (Adjustment): Dr Prepaid [Expense] / Cr [Expense]
  • If omitted: expense overstated → profit understated
• First day of next period (Reversal): Dr [Expense] / Cr Prepaid [Expense]

Step-by-Step Approach

Step 1 — Record the payment when made:

Step 2 — Year-end: Set aside the unused portion as prepaid expense

Step 3 — Start of next financial period: Reverse the prepaid expense

Why reverse? The service is now used up this year, so the amount set aside last year becomes this year's expense.

Effects If Adjustment Not Made

If the year-end adjustment (Step 2) is not made:

• Expense is overstated → Profit is understated (expense and profit move in opposite directions)
• Prepaid expense is not recorded → current asset is understated

 1 Apr 20X5          31 May 20X5                      31 Mar 20X6
    |—— 2 months ——|———————— 10 months unused ————————|
    | used (Apr–May) |  (Jun onward: not yet used)

Statement of Financial Position (extract)

Tip — Finding a missing figure

An expense account is built from up to four pieces:

• Opening reversal — last year's adjustment reversed at the start of this year (may or may not appear)
• Cash paid — cash paid during the year (Cash at bank / Cash in hand)
• Year-end adjustment — expense used but not yet paid added on (expense payable), or expense paid but not yet used set aside (prepaid expense)
• Expense incurred — the amount closed to Income summary; this is the expense for the year

A question gives you all but one and leaves the last for you to find. These pieces are linked by one relationship:

Expense incurredfx

Expense incurred = cash paid + expense payable − prepaid expense

In plain terms: start from the cash, add what was used but not yet paid (expense payable), and take away what was paid but not yet used (prepaid expense). Rearrange this to find whichever piece is missing.

Harder case — an opening reversal. Most questions use only the three pieces above. Some also show an opening reversal at the start of the year. A reversal cancels last year's year-end adjustment, so it moves the opposite way to a year-end adjustment of the same name:

• Prepaid expense brought in from last year → add it (the cash was paid last year, but it is used this year)
• Expense payable reversed out from last year → subtract it (it was already counted as expense last year, but the cash only goes out this year)

Missing the expense incurred? Work forward.
Cobblestone Trading paid $48,000 in salaries in cash during the year ended 31 December 20X5. At year end, $2,000 of salaries had been used but not yet paid. There were no opening balances.

Expense incurred = cash paid + used but not yet paid
= $48,000 + $2,000 = $50,000

Missing a component (cash paid or an adjustment)? Work backwards.
Saffron Trading's insurance expense for the year ended 31 December 20X5 was $9,000. On 1 January, $800 prepaid was brought into this year; on 31 December, $1,000 was set aside as prepaid. Find the cash paid during the year.

Cash paid = expense incurred + set aside this year (adjustment) − brought in from last year (reversal)
= $9,000 + $1,000 − $800 = $9,200