Prepaid Expenses

Prepaid Expenses

When a business pays for an expense before the benefit of that expense has been fully received, the portion that relates to the next accounting period is called a prepaid expense. This is a common occurrence — rent paid for the full year when only 9 months have passed, insurance paid in advance, or salary given to an employee before it is earned.

The key idea is simple: you have paid cash, but you have not yet consumed the service or benefit. That unexpired portion is not an expense of the current year; it is an asset. It represents a future economic benefit — the right to receive the service without paying again.

Accounting Treatment

The adjustment for prepaid expenses is made at the end of the accounting year with the following journal entry:

Why is the expense account credited? Because the expense account currently shows the full amount paid. But part of that amount does not belong to this year. By crediting the expense account, we reduce it to the correct figure for the current period. The prepaid expense account (a current asset) is debited to recognise the future benefit.

Effect on Financial Statements

The adjustment has two effects:

1. In the Profit & Loss Account — The prepaid portion is deducted from the total of that expense. Only the expense actually incurred during the current year is shown.
2. In the Balance Sheet — The prepaid amount appears as a current asset on the assets side.

Worked Example

Ankit paid ₹25,000 as salary during the year. However, ₹5,000 of this was paid in advance to an employee who had just joined. This means the correct salary expense for the current year is ₹20,000 (₹25,000 − ₹5,000). The ₹5,000 is a prepaid salary — a current asset.

Adjusting Journal Entry

Presentation in the Profit & Loss Account

Notice that the net profit is ₹24,000. If the prepaid adjustment had not been made, the salary expense would have been ₹25,000 and net profit would have been only ₹19,000. The prepaid adjustment increases profit by ₹5,000 — because that ₹5,000 is not a cost of this year.

Presentation in the Balance Sheet (Assets Side)