Where a prepaid expense adjustment is required we will move a cost from the current period into the next accounting period. This will be achieved by reducing one of the business’ expenses and creating an asset at the end of the accounting period. Then at the start of the next period we will reverse this prepayment.
There are two ways to record a prepaid expense in the General Ledger:
- By using a separate Prepayments account
- Without using a separate Prepayments account
We will illustrate how both methods work using the scenario below:
A business has a year end of 31st December. On 1st September 2019 the business paid £4,800 for insurance cover for the period from 1st September 2019 to 31st August 2020.
Four months of the insured period (i.e. September to December 2019) fall in the year-ended 31st December 2019 and the remaining eight months are in the year ended 31st December 2020.
As such, 8/12th of the amount paid (i.e. 8/12 x £8,400) has been prepaid and an adjustment is required to move £5,600 out of the Insurance account for the year ended 31st December 2019 and into the account for the next year.
Recording an prepaid expense using a separate prepayments account
The reduction to the expense will be credited to the expense account and the balancing debit will be recorded in a prepayments account.
We will therefore record the following journal.
The journal will then be entered in the General Ledger accounts as shown below. The journal postings are recorded in blue and the original bank payment for the insurance is shown in black.
Once the year-end prepayment is posted we can close the accounts down. The prepayments account balance represents an asset, that is, its entitlement to receive insurance cover for part of the next year. As such the balance on the prepayments account will be carried down to the start of the next period. The insurance account however, is an expense account and its balance will be sent to the Profit & Loss account using the following journal.
The above journal will be posted into the General Ledger and the two accounts can be closed down for the year.
At the start of the new accounting period
At the start of the next accounting period (in this example, on 1st January 2020), we will bring the balance down on the prepayments account and then reverse the prepayments journal. This will have the effect of cancelling the asset and increasing the insurance expenses for this period by the amount that was prepaid in the previous accounting period.
The journal will be posted to the General ledger as shown below.
If we now look at the Insurance account there is a balance of £5,600 representing the insurance cost for January to August 2020 that was paid for in the previous year.
Recording a prepaid expense without using a separate prepayments account
The prepaid expense can also be recorded without using a prepayments account. Where this is done, the year-end prepayment will simply be recorded as a balance to be carried down on the credit side of the expense account which will then be brought down on the debit side of the account at the start of the next period (see below).
The advantage of this second method is that no reversal of a year-end prepayment is required at the start of an accounting period. The disadvantage however, is that it makes it harder for an accountant to keep track of all the prepayments existing at the year-end as they might be recorded as balances carried down in several different ledger accounts.