Ch. 3 Assets and Liabilities
3.2 Prepaids
Learning Objectives
After finishing this section, students will be able to:
- Recognize how much should be expensed each month to use prepaid assets.
If you have a gym membership, you pay at the start of the month to be able to use the gym throughout the month. Your gym membership is one idea of a prepaid expense. It is your choice whether you choose to use the gym membership to your benefit.
Prepaid Expenses
Prepaid expenses are items paid for in advance of their use. They are considered assets until used. Some examples include insurance, marketing, and rent.
Prepaid Insurance
Insurance, for example, is usually purchases and pays for more than one month at a time (six months typically). The company does not use all six months of the insurance at once so it cannot be put in the income statement until it has been used. Instead the company uses the insurance one month at a time and tracks the unused balance on the balance sheet. As each month passes, the company will adjust its records to reflect the cost of one month of insurance usage.
For example, a company pays $4,500 for an insurance policy covering six months. It is the end of the first month and the company needs to record an adjusting entry to recognize the insurance used during the month. The following entries show the initial payment for the policy and the subsequent adjusting entry for one month of insurance usage.
In the first entry, Cash decreases (credit) and Prepaid Insurance increases (debit) for $4,500. In the second entry, Prepaid Insurance decreases (credit) and Insurance Expense increases (debit) for one month’s insurance usage found by taking the total $4,500 and dividing by six months (4,500/6 = 750). Notice the account totals at the end. The asset, Prepaid Insurance, is adjusted at the end of each month to make sure the appropriate expense is on the income statement.
| Balance Sheet | Income Statement | Stmt of Cash Flows | |||||||||||||
| Cash | + | Prepaid Insurance | = | Liability | + | Common Stock | + | Retained Earnings | Revenue | – | Insurance Expense | = | Net Income | Cash | OA,IA,FA |
| -4,500 | 4,500 | = | -4,500 | OA | |||||||||||
| -750 | -750 | – | 750 | = | -750 | ||||||||||
| -4,500 | 3,750 | -750 | – | 750 | – | -750 | Totals | ||||||||
Prepaid Rent
Similar to prepaid insurance, rent also requires advanced payment. Usually to rent a space, a company will need to pay rent at the beginning of the month. The company may also enter into a lease agreement that requires several months, or years, of rent in advance. Each month that passes, the company needs to record rent used for the month.
Let’s say a company pays $8,000 in advance for four months of rent. After the first month, the company records an adjusting entry for the rent used. The following entries show initial payment for four months of rent and the adjusting entry for one month’s usage.
In the first entry, Cash decreases (credit) and Prepaid Rent increases (debit) for $8,000. In the second entry, Prepaid Rent decreases (credit) and Rent Expense increases (debit) for one month’s rent usage found by taking the total $8,000 and dividing by four months (8,000/4 = 2,000). The asset, Prepaid Rent, is adjusted at the end of each month to make sure the appropriate expense is on the income statement.
| Balance Sheet | Income Statement | Stmt of Cash Flows | |||||||||||||
| Cash | + | Prepaid Rent | = | Liability | + | Common Stock | + | Retained Earnings | Revenue | – | Rent Expense | = | Net Income | Cash | OA,IA,FA |
| -8,000 | 8,000 | = | -8,000 | OA | |||||||||||
| -2,000 | = | -2,000 | – | 2,000 | = | -2,000 | |||||||||
| -8,000 | 6,000 | = | -2,000 | – | 2,000 | – | -2,000 | Totals | |||||||
3.2a Example
The following transactions for CozyCrate occurred. CozyCrate is a service company that does not carry inventory.
| Oct. 1 | Issued common stock of $20,000. |
|---|---|
| Oct. 1 | Paid $2,000 for first and last month’s rent . |
| Oct. 8 | Billed customers on account for $15,000. |
| Oct. 15 | Paid $5,000 for a yearly insurance policy. |
| Oct. 22 | Received utility bills for $3,000. |
| Oct. 30 | Paid employees $4,000. |
| Oct. 31 | What transactions still need to be made? |
Instructions:
- Using the Horizontal Model, prepare entries for the above transactions.
- Create a balance sheet as of October 31, 20X9.
3.2a Practice
The following transactions for Dinosaurs, Inc. occurred on February 1. Dinosaurs, Inc. is a service company that stores dinosaurs in a climate-controlled location. Beginning balances for Dinosaurs are Cash, $20,000 and Common Stock, $20,000.
| Date | Transaction Detail |
|---|---|
| Feb 1 | Signs and pays for a one-year lease on a warehouse for $12,000. |
| Feb 10 | Upon signing a the one-year lease agreement for the warehouse, the company also purchases and pays for a 6-month insurance policy for $7,500 |
| Feb 28 | What transactions still need to be made? |
Check Figures:
- Cash, $500
- Net Income, $-2,250 (no money has been collected yet for the business)
- Solution (Excel file will download)
3.2a Homework
The following transactions for Space Guardian occurred. Space Guardian is a service company that does not carry inventory.
| Nov. 1 | Issued common stock of $35,000. |
|---|---|
| Nov. 1 | Paid $9,000 for the next six month’s rent. |
| Nov. 8 | Received cash from customers of $10,000 |
| Nov. 22 | Paid $1,500 for a three month insurance policy. |
| Nov. 30 | Paid employees $4,000. |
| Nov. 30 | What transactions still need to be made? |
Instructions:
- Using the Horizontal Model, prepare entries for the above transactions.
- Create an income statement as of November 30, 20X6. The income tax expense for Space Guardian is 21%.
- Create a balance sheet as of November 30, 20X6.
- Create a cash flow statement as of November 30, 20X6.
Licensing and Attribution:
Content on this page is adapted from the following openly licensed resource(s):
Principles of Accounting, Volume 1: Financial Accounting by Mitchell Franklin, Patty Graybeal, and Dixon Cooper licensed under a Creative Commons Attribution-NonCommercial-ShareAlike 4.0 International License
are items paid for in advance of their use.
