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How Prepaid Expenses Work | Adjusting Entries - YouTube

Channel: Accounting Stuff

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in this video we're going to walk

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through the accounting treatment of

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prepaid expenses step-by-step hey there

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welcome back to the channel I'm James

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this is accounting stuff and in a few

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moments we're going to work through a

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complete prepaid expense example but

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Before we jump in I want to point out

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that this video is part of a miniseries

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that I've created covering adjusting

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entries in accounting which you can find

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linked up here and down below in the

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description if you've been having

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trouble with pre payments or accruals

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then I highly recommend you check out

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these videos especially the first one

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where I explain the theory behind

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adjusting entries and how they all fit

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into the big picture of accounting but

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in this video we're going to get our

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hands dirty with a practical example on

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prepaid expenses you'll find out how to

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recognize a prepaid expense and then

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we'll walk through the adjusting

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journals but all of the affected

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accounting periods I'm going to be

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releasing more videos covering deferred

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revenue accrued expenses and accrued

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revenue all of that is coming soon so

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hit the subscribe button and click on

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the bow so you don't miss out on any of

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those let's go but first let's clarify

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what a prepaid expense actually is a

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prepaid expense is a future expense

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which has been paid for in advance now

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what does that mean

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it means that we made the payment in a

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past accounting period but we don't

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actually receive the underlying goods or

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services until a future accounting

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period right time for an example but

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first I want you to meet someone

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[Music]

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this is Betty my humble Toyota Yaris

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she's not the biggest and she's

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certainly not the fastest in fact she's

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kind of old but she moves me around from

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A to B and for that privilege I have to

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buy car insurance

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unfortunately I live in Vancouver which

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has some of the highest auto insurance

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premiums in Canada poor Betty who I

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bought for $3,000 cost me a whopping

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2,400 to insure for 2019 I paid for this

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in advance on December 15th 2018 and I

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initially coded the whole payment to

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insurance expenses

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question.what monthly adjusting entries

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do we need to post to record this

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transaction in line with the accrual

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basis of accounting we'll begin by

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taking stock of the facts at the end of

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2018 we'd already paid for our insurance

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coverage for the following year so this

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was a future expense which I had paid

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for in advance does that sound familiar

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yes we are dealing with a prepaid

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expense I paid two thousand four hundred

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dollars in advance on December 15th 2018

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which I coded to the insurance expense

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account now what would that journal

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entry look like well I paid out $2,400

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so my cash balance has to decrease by

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two thousand four hundred cash is an

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asset which is the a in dealer that

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makes it a normal debit account so

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debits increase it and credits decrease

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it that means that on December 15th I

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would have credited my cash account by

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$2,400 I already said that the other

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side of the journal went to the

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insurance expense account

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well expenses of the e'en dealer also a

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normal debit account so to increase them

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I would have debited the insurance

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expense account by $2,400 here we have

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the initial journal entry when I post it

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is it would have hit both the cash

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account in the balance sheet and the

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insurance expense account in the income

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statement we can visualize the impact

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this journal entry on the general ledger

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using T accounts in T accounts debits

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always go on the left and credits always

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go on the right so this is the result of

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that initial entry back in December 2018

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and it would have been fine if we were

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cash accounting because when we cash

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account we record expenses once cash is

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paid out but the problem is we're

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accrual accounting so expenses should

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always be recorded as they are incurred

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and that means that our expenses at the

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end of 2018 are overstated by $2,400

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time for our first adjusting entry I'm

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going to show you how to record a

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prepaid expense we're going to need to

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post this one into the December 2018

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accounting period before it gets closed

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for good

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our insurance expense account is

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overstated by $2,400 so our adjusting

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journal needs to clear all of this out

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last time we debited the account so this

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time we need to credit the insurance

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expense account by $2,400 but where does

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the other side of this journal entry go

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we comput us anywhere in the income

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statement because that will affect our

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profit for the year that leaves us with

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one option the balance sheet but we're

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in the balance sheet is a prepaid

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expense an asset or a liability well

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there's an easy way to check this assets

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bring us future economic benefit whereas

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liabilities involve a future economic

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sacrifice in this situation I've already

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paid for the car insurance so now it's

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down to the insurance company to provide

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me with coverage for the next 12 months

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I'm going to receive the benefit of that

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coverage so this prepaid expense should

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be recognized as an asset in the balance

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sheet in fact prepaid expenses are

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always recognized as assets in the

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balance sheet that means the other side

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of the journal entry is a debit of two

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thousand four hundred two prepaid

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expenses in the balance sheet let's

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update our T accounts to find out what

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impact this journal entry had on the

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general ledger so at the end of 2018 we

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have negative cash of two thousand four

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hundred dollars no

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insurance expenses their income

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statement and a $2,400 prepaid expense

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which we're holding as an asset in the

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balance sheet this is exactly where we

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want to be now when it comes to 2019 we

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have some more adjusting entries to post

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12 in total one for each month of the

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year so let's bring up a timeline for

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2019 and break it down into twelve

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accounting periods from January 1st

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all the way through to December 31st in

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accrual accounting expenses are recorded

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as they are incurred so we need to

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release our prepaid expense from the

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balance sheet as we consume or get the

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benefit from our insurance policy in

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January 2019 I've consumed 1/12 of the

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insurance coverage 1/12 of $2,400 is

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$200 so the insurance expense that we

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need to recognize in our income

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statement is $200 for January 2019 the

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adjusting journal entry that we need to

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post looks like this we need to debit

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the insurance expense account by $200 to

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increase our expenses in the income

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statement and we need to credit prepaid

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expenses by $200 to decrease our assets

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in the balance sheet so with 11 months

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of insurance coverage left on the policy

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we're carrying $2,200 of prepaid

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expenses as an asset in the balance

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sheet and we've incurred an insurance

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expense of $200 in the income statement

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this process of releasing pre payments

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from the balance sheet needs to continue

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for the rest of the year at the end of

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May we've consumed five twelfths of our

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insurance coverage so we need to have

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posted this journal entry 5 times

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recognizing a $200 insurance expense in

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the income statement on each occasion

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with seven months of insurance coverage

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left on our policy we have $1,400 of

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prepaid expenses held in the balance

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sheet and $1,000 of insurance costs

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expensed in our income statement five

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months of policy consumed over a

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12-month period which gives us $1,000

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likewise you could do the same to work

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out the prepaid expense in the balance

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sheet we have seven months of coverage

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or future economic benefit left on the

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policy so we have prepaid expenses of

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$2,400 multiplied by seven over 12 which

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gives us an asset of one thousand four

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hundred dollars in the balance sheet

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come December 31st the adjusting entry

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we need to post is exactly the same as

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the ones that we posted for the previous

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11 months debit insurance expenses by

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$200 in the income statement and credit

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prepaid expenses by $200 in the balance

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sheet however this time we've consumed

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all of our insurance policy we are no

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longer expecting to get any future

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economic benefit so we are no longer

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holding any prepaid expenses in the

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balance sheet this asset has been

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reduced to zero because we have released

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all of it to the income statement where

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we have recorded an insurance expense of

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$2,400 for 2019 our cash account is

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still showing a credit for December in

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the prior year because that's when we

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paid for the policy so we've recorded

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our expenses as we incurred them and our

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books are in line with the accrual basis

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of accounting I'm going to be releasing

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