224 prepayments businesses also make prepayments to

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2.2.4 Prepayments Businesses also make prepayments to suppliers which need to be recorded as well. We can record them in various accounts that typically start with the term "prepaid." For example, the account "prepaid insurance" would be used to record the value of insurance that is paid up front. The journal entry to record one year of prepaid insurance for Bikram Yoga Natick would look like this.
Prepaid Expense is NOT an Expense Account Similar to Deferred Revenue, the Prepaid Expense account can be confusing at first glance. Even though it has the word ‘expense’ as part of its account name, it is not an expense account. Prepaid Expense is an asset account. It represents an amount that has been prepaid by the business, and thus the business now has the right to receive goods or services in the future. Prepaid expense will be converted into an expense at a later date, when the goods or services are provided. This, again, is an example of accrual accounting and the matching principle . Prepayments, Continued The process for recording prepayments and the use of the related benefits is similar to the process we just learned about for recording payments received in advance. Let's continue with the example where Bikram Yoga Natick prepays $2,400 for one year of insurance on January 1, 2013. The initial journal entry on January 1, 2013 records a debit to Prepaid Insurance (an asset) and a credit to Cash, as shown below. This increases the balance in Prepaid Insurance and decreases the balance in Cash. Prepaid Insurance is an asset because by prepaying for an entire year of insurance, Bikram Yoga Natick is now entitled to receive insurance benefits throughout the year. Companies may sometimes call an account like this Prepaid Insurance Expense, or simply, Prepaid Expenses. Even though the word "Expense" may be in the account name, remember that prepaid expenses are actually assets.
Since the benefits provided by the Prepaid Insurance will cover an entire year, Bikram Yoga Natick needs to recognize the expense for insurance coverage evenly throughout the year. To do this, Bikram Yoga Natick will record a journal entry at the end of the month to record a month's worth of insurance coverage used. To calculate a month’s worth of insurance coverage, we take the total amount paid divided by the number of months. $2,400 / 12 = $200 per month. The journal entry on January 31, 2013 records a debit to Insurance Expense and a credit to Prepaid Insurance, as shown below. This increases the balance in Insurance Expense and decreases the balance in Prepaid Insurance. A similar entry is made again on February 28, 2013, as shown below. After 12 months of recording these journal entries at the end of each month, the Prepaid Insurance balance will be back down to zero, and all $2,400 of the prepayment will have been recognized as an expense.

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