As mentioned before, prepaid expenses are assets for goods or services that you pay for in advance. However, these lose their worth steadily over time until they no longer have any value. Thus need to be corrected via an Adjusting Journal Entry.
An Adjusting Journal Entry is exactly like it sounds—a journal entry to adjust the value of an account. In the case of prepaid expenses, it is usually important to adjust the value at the end of every month specifically. This gives a more accurate value of the asset, so it isn’t misstated in financial statements.
In the case of prepaid expenses like insurance, the usual method of creating an adjusting entry is to divide the original value of the asset by the time-period and subtract that from it each month. Once you have the adjusting value, you would credit the prepaid account by that amount and debit the relevant expense account by the same amount at the end of the month. To demonstrate the necessary journal entries, let us say you paid $1,200 for an insurance policy that lasts for 12-months on January 1st, 2021.
Jan 1st: Prepaid Insurance $1,000
Cash $1,000
If the policy lasts for 12-months, then its value would be entirely used up by the start of the next year. So you would need to take the adjusting value and then subtract it every month by one-twelfth of its initial value, which is $100 in this particular example. So once January 31st, 2021 rolls around, you would need to make the following adjusting entry:
Jan 31st: Insurance Expense $100
Prepaid Insurance $100
At the end of the year, the Prepaid Insurance will be reduced to zero, while the Insurance Expense will have the entirety of the value. At this point, if you intend to renew your policy or purchase additional insurance, you will once more enter the initial exchange of Cash into the Prepaid Insurance accounts.
We will cover more bookkeeping information as the year continues, so please subscribe to our blog and feel free to Contact Us if you want our help leaving your books in the black.
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