Prepayments

Prepayments are those which the firm has recorded the transaction as a journal entry, but has not yet realized the revenue or expense associated with the journal entry. Examples of prepaid items would be prepaid insurance, prepaid rent, office supplies, depreciation, or any unearned value.

Consider the case of renting an office space. Suppose we have received the bill for rent on February 1 for the year for $120,000 for 12-months. The bill has been posted to the Rent account when entered onto the supplier ledger account. If you leave it, you would expect the whole value ($120,000) to hit your expense for the month. So, it is recommended to do a prepayment for this.

Because Rent is a prepaid expense, the journal entry on Feb 1 would look like the following:

Date

Account Titles and Explanation   Debit

Credit

2/1 Prepaid Expenses   120000  
 

Cash

   
 

12 month rent or commercial space

  120000

The result of this entry is that the rent becomes an asset in the Prepaid Expenses account. At the end of September, this asset will be adjusted to reflect the amount "consumed" during the month. The adjusting entry would be:

Date

Account Titles and Explanation   Debit

Credit

2/1 Rent 10000  
 

Prepaid Expenses  

   
 

Rent expense for February

  10000

This adjusting entry transfers $10000 from the Prepaid Expenses asset account to the “Rent Expense” expense account to properly record the rent paid for the month of February. In this example, a similar adjusting entry would be made for each subsequent month until the contract expires 11 months later.

In the case of unearned revenue, a liability account is credited when the cash is received. An adjusting entry is made once the service has been rendered or the product has been shipped, thus realizing the revenue.