Definition of Adjusting Prepaid Expenses
If the company issues financial statements at the end of each calendar month, the balance in the account Prepaid Expenses must be adjusted so that the balance sheet reports the amount that is actually prepaid (not yet expired) at the end of the month. If the company issues only quarterly financial statements, the account balance in Prepaid Expenses must report the actual amount that is actually prepaid (not yet expired) at the end of the quarter.
Example of Adjusting Prepaid Expenses
Assume that a company's only prepaid expense is the prepaid premiums on its liability insurance policy. Also assume that on December 1, the company paid $6,000 for the insurance coverage from December 1 through May 31. The company recorded the December 1 payment with a debit of $6,000 to Prepaid Insurance and a credit of $6,000 to Cash.
On December 31, the account Prepaid Expenses must be adjusted to report a balance of $5,000 since the amount prepaid is decreasing by $1,000 a month. Therefore, an adjusting entry must be recorded as of December 31 to credit Prepaid Expenses for $1,000 and to debit Insurance Expense for $1,000.
The same adjusting entry must be recorded as of the last day of January, February, March, April, and May.