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 |
Prepaid |
Insurance |
|
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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