Prepaid Expense and Income

Prepaid Expense

Prepaid expense is expense paid in advance but which has not yet been incurred. Expense must be recorded in the accounting period in which it is incurred. Therefore, prepaid expense must be not be shown as expense in the accounting period in which it is paid but instead it must be presented as such in the subsequent accounting periods in which the services in respect of the prepaid expense have been performed. Entity should therefore recognize an asset in respect of expense it has paid in advance until such time as the services that are due in relation to the prepaid expense have been performed by the suppliers/contractors. Following accounting entry is required to account for the prepaid expense:

Debit                            Prepaid Expense (Asset)

Credit                           Cash

Example

ABC LTD pays advance rent to its landowner of $10,000 on 31st December 2014 in respect of office rent for the following year.

ABC LTD has an accounting year end of 31^st December 2014. ABC LTD will recognize an asset of $10,000 in the financial statements of year 2014 in respect of the prepaid expense to recognize its right to use office space in the following year. Following accounting entry will be recorded in the books of ABC LTD in the year 2014:

Debit                            Prepaid Rent                            $10,000

Credit                           Cash                                        $10,000

The prepaid expense will be recognized as expense in the next accounting period to which the rental expense relates. Following accounting entry will be recorded in the year 2015:

Debit                            Rent Expense (Income Statement)       $10,000

Credit                           Prepaid Rent                                        $10,000

Prepaid Income

Prepaid income is revenue received in advance but which is not yet earned. Income must be recorded in the accounting period in which it is earned. Therefore, prepaid income must be not be shown as income in the accounting period in which it is received but instead it must be presented as such in the subsequent accounting periods in which the services or obligations in respect of the prepaid income have been performed. Entity should therefore recognize a liability in respect of income it has received in advance until such time as the obligations or services that are due on its part in relation to the prepaid income have been performed. Following accounting entry is required to account for the prepaid income:

Debit                            Cash/Bank

Credit                           Prepaid Income (Liability)

Example

ABC LTD receives advance rent from its tenant of $10,000 on 31st December 2014 in respect of office rent for the following year. ABC LTD has an accounting year end of 31^st December 2014.

ABC LTD will recognize a liability of $10,000 in the financial statements of year 2014 in respect of the prepaid income to acknowledge its obligation to make the office space available to the tenant in the following year. Following accounting entry will be recorded in the books of ABC LTD in the year 2014:

Debit                            Cash                                                    $10,000

Credit                           Prepaid Rent Income (Liability)                       $10,000

The prepaid income will be recognized as income in the next accounting period to which the rental income relates. Following accounting entry will be recorded in the year 2015:

Debit                            Prepaid Rent Income (Liability)                       $10,000

Credit                           Rent Income (Income Statement)         $10,000