What are Prepayments And Its Accounting Treatment?

July 4th, 2006 Comments off
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During the accounting cycle, prepayments form one part of the adjusting entries. After the draft trial balance is extracted, the bookkeeper will then look for adjusting entries like prepayments  to be expensed off into the Income Statement?

So what are Prepayments?

Prepayments or prepaid expenses are expenses paid in advance.

They are actually economic resources which are the current assets of a business which are expected to be used up or consumed during the accounting period of the business.

The portion that are used up during the accounting period are treated as expenses in the Income Statement whilst those not consumed are treated as a current asset which is called prepayment or prepaid expenses

 

Examples are: prepaid insurance (unexpired insurance),prepaid rent, prepaid advertising, prepaid road tax and prepaid property tax which are reflected in the current assets of the Balance Sheet.

 

Prepayments expensed into Income Statement following the Matching Concept

This in reality is following the matching concept. Those expenditures that are used up to match the revenue generated for the accounting period is EXPENSED off into the Income Statement.

What are the Accounting Treatment for Prepayments?

Basically there are two(2) ways of accounting treatments:

·Treat the prepayment initially as an expense in the Income Statement:

 

Debit: Expenses ( Income Statement)say  $10,000

Credit: Bank/Cash $10,000

 

Being 100% take up of prepaid expenses as expenses in the Income Statement.

 

 

Next , at the end of the accounting period, use the following adjusting entry to transfer those portion that has not been used up to the Balance Sheet as current asset/prepayment

Accounting entry as follows:

 

Debit: Prepayment (Balance Sheet)  $6,000

Credit: Expenses (Income Statement)         $6,000

 

Being transfer of the portion of expenses not expired/consumed into prepayment account (balance sheet) leaving $4,000 as expenses in the Income statement.

 

·       Another accounting method is to treat the expenditure of $10,000 as prepayments as current assets in the Balance Sheet instead of the first method of taking up as expenses

 

Debit: Prepayment (Balance Sheet) $10,000

Credit: Bank/Cash  $10,000

 

Being initial complete take up as prepayment  $10,000

 

 

Next, at the end of the accounting period, transferred the portion that has expired or used up as expenses into the Income Statement:

 

Debit: Expenses ( Income Statement)  $4,000

      Credit: Prepayment (Balance Sheet)     $4,000

 

Being transfer from prepayment to expenses for the portion that has expired namely $4,000.

 

Salient point on the abovementioned methods of Accounting treatment of prepayment:

In both methods, whether initially being taken up into balance sheet or income statement respectively and then transferred out as expenses or as prepayments/current assets, only the portion of the expense that has actually expired or used up which in this case is $4,000 is matched against the revenue generated during the accounting period

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Financial Accounting

 
 

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