Why is it important to determine whether the prepayment should be recognized as current asset or as an expense when preparing adjusting entries?

Answer 1

The importance of recognizing a prepayment as a current asset when preparing adjusting entries is to appropriately match the expense to the period in which the expense is incurred. This matching of revenue and expense to the proper period is a basic principle of accrual based accounting.

For example, the most common of prepayments is insurance. Most insurance policies require a down payment of 30% and equal payments for nine months thereafter. If the payment is posted directly to expense there will be 30% in the first month and approximately 7.78% in the next nine months and 0% in the last two. However, the insurance expense should be recorded as 1/12 or 8.3% per month. By posting the payments to a current asset account as a prepayment and posting a recurring entry each month that debits insurance expense and credits the current asset, you will record the expense evenly over the year as the policy expires.

The importance of this method of recording a prepaid expense is more important if there is unexpended expense at the end of the operating cycle. If the prepayment is appropriately expended during the operating cycle, the monthly accounting will be distorted but the annual numbers will be correct. If the prepayment extends into the next operating cycle, the operating cycle with the payment will have an overstated expense and the subsequent operating cycle will have a understated expense.