Two ways of accounting for prepaid expenses

2.1. Balance sheet approach

We will further assume that the company does not adjust the prepaid insurance balance until the end of the fiscal year (December 31, 20X0).

At the end of the calendar (fiscal) year December 31, 20X0 the company will have $8,000 (4 months x $2,000 monthly expense) left as unused prepaid insurance expense. Considering this, the company will need to adjust its prepaid insurance balance of $24,000 to make it $8,000, and the difference ($16,000) will be recorded as insurance expense for the year.

The following journal entries will be recorded by the company:

a) To record the premium payment on April 15, 20X0:

Account Titles

Debit

Credit

Prepaid Insurance

24,000

 

      Cash

 

24,000

b) To record insurance expense for year 20X0 (8 months) on December 31, 20X0:

Account Titles

Debit

Credit

Insurance Expense

16,000

 

      Prepaid Insurance

 

16,000

As you can see, the company applied the balance sheet approach to account for its prepaid insurance. In particular, the company calculated what balance of prepaid insurance should remain on the balance sheet and made the necessary adjustment.

2.2. Income statement approach

The company could also have applied another way of accounting for prepaid insurance. Assume the same scenario as before. However, this time the company recorded the entire amount of prepaid insurance of $24,000 as insurance expense in the income statement at the time of the premium payment. At the end of the year, the company calculated what the insurance expense for 20X0 should have been. The insurance expense was determined as follows: 8 months x $2,000 = $16,000. The company then adjusted the insurance expense by moving the difference ($8,000) from the income statement to the balance sheet.

The following journal entries would have been recorded by the company:

a) To record premium payment on April 15, 20X0:

Account Titles

Debit

Credit

Insurance Expense

24,000

 

      Cash

 

24,000

b) To record prepaid insurance balance at the end of year 20X0 (4 months remaining):

Account Titles

Debit

Credit

Prepaid Insurance

8,000

 

      Insurance Expense

 

8,000

This is the income statement approach because the company initially recorded the entire insurance premium as insurance expense and then adjusted the expense (by allocating a portion of it to the balance sheet) at the end of the year.

2.3. Comparison of two methods of accounting for prepaid expense

Let us now go back to the two scenarios and compare results:

 

Balance Sheet Approach

Income Statement Approach

Prepaid
Insurance

Insurance
Expense

Prepaid
Insurance

Insurance
Expense

April 15, 20X0:

Premium Payment

$24,000

$0

$0

$24,000

December 31, 20X0:

Year-end Adjustment

($16,000)

$16,000

$8,000

($8,000)

December 31, 20X0:

Ending Balance

$8,000

$16,000

$8,000

$16,000

As you can see, no matter which approach is selected, the ending balances in the prepaid insurance (balance sheet) and the insurance expense (income statement) will be the same.

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