- If a prepaid expense is recorded initially as an expense, then at the end of an accounting period, only the true expense amount for the period should remain in the expense account. The future expense (the portion that has not yet expired; the unexpired part) must be credited to the expense account and debited to the prepaid asset account.
- If a prepaid expense is recorded initially in a prepaid asset account, the true expense of the period (the expired portion) needs to be removed and debited to the related expense account. The remaining amount in the prepaid asset account should be the unexpired portion.
Let's illustrate these two possibilities by assuming that an insurance premium of $6,000 is paid on December 1. This cost covers the six month period of December 1 through May 31. As a result the monthly expense will be $1,000. Let's also assume that the company did not have any insurance prior to December 1.
- On December 1, the account Insurance Expense was initially debited for $6,000 and Cash was credited for $6,000. On December 31, an adjusting entry will be needed to debit Prepaid Insurance for $5,000 and to credit Insurance Expense for $5,000. After this adjusting entry is recorded, the balance in Insurance Expense will be December's true expense of $1,000 (original debit of $6,000 minus the adjusting entry credit of $5,000) and the balance in Prepaid Insurance will be the debit of $5,000. This represents five months of cost that has not yet expired (5 months x $1,000 per month).
- On December 1, the account Prepaid Insurance was initially debited for $6,000 and Cash was credited for $6,000. On December 31, an adjusting entry will be needed to debit Insurance Expense for $1,000 (the amount that expired during December) and to credit Prepaid Insurance for $1,000. After this adjusting entry is recorded, the balance in the asset Prepaid Insurance will be $5,000 (the initial debit of $6,000 minus the credit of $1,000; and the unexpired amount consisting of 5 months x $1,000 per month). The account Insurance Expense will report the debit of $1,000.
Usually there would be insurance coverage prior to December 1. In that case the year-to-date balance in the expense account should be equal to the expired insurance cost during the year-to-date period. If there is a conflict between getting the prepaid asset balance to be correct and the expense balance to be correct, make certain that the prepaid asset balance is correct.