Method 1: the two accounts method
This is the easier approach. Also note that
it is the method used in computerized accounting systems.
The prepayment is estimated and then
transferred from the expense account to a prepayment account:
Illustration: Prepayment using two accounts.
Debit Credit
Prepayment account (an asset) X
Expense account
X
The prepayment is a credit entry in the
expense account therefore reducing the expense recognised in the current
period.
The debit balance on the prepayments account
is included in the statement of financial position as a current asset.
Fahad set up in business on 1 January Year 1 preparing financial
statements to 31
December each year..
On 1 March he obtains annual insurance on his office building,
starting from 1
March at cost of Rs. 24,000, payable annually in advance.
10 months of the insurance cost relates to the current financial
period (Year 1) and
2 months of it relates to insurance in the next financial year
(January and February Year 2).
The charge to the statement of comprehensive income for insurance
in Year 1 should therefore be Rs. 20,000 (Rs. 24,000 × 10/12).
The prepaid expense for Year 2 is Rs. 4,000 (Rs. 24,000 × 2/12).
Method 1: two
accounts approach
 |
| two accounts approach |
Reversal of the prepayment
At the beginning of the next accounting
period, the balance in the prepayments account is transferred back to the
expense account so that it will be recognized as an expense in the next
accounting period.
Example (continued): Reversal of the prepayment (at the start of
year 2)
The following double entry is processed at the start of year 2:
Debit Credit
Insurance expense 4,000
Prepayments 4,000
This reinstates the prepayment as an expense that relates to the
second year.
Example (continued): Year 2
In Year 2, the annual insurance premium payable on 1 March is Rs.
30,000 for the year to 28 February Year 3.
The prepaid expense at the end of Year 2 is therefore Rs. 5,000
(Rs. 30,000 × 2/12) and the insurance
expense in Year 2 is accounted for as follows:
Method 1: two
accounts approach
The
expense in the statement of comprehensive income is Rs. 29,000.
This
consists of the prepayment at the beginning of the year (Rs. 4,000 for January and
February) plus the expense for the 10 months from March to December ((Rs.
30,000
× 10/12)
= Rs. 25,000).
The
prepaid expense of Rs. 5,000 at the end of Year 2 is included in the statement of
financial position as a current asset.
Method 2: the one account method
This approach is trickier to understand. The
prepayment is recognised in the expense account.
There are two ways of achieving this.
- The total expense can be calculated and transferred to the statement of comprehensive income (Dr Statement of comprehensive income; Cr
Expense account) leaving a balancing figure
on the expense account as a prepayment; or
- The prepayment can be calculated and recognised in the expense account leaving the amount transferred to the statement of comprehensive income (Dr Statement of comprehensive income; Cr Expense account) as a balancing figure.
Example: Year 1
Fahad set up in business on 1 January Year 1 preparing financial
statements to 31
December each year..
On 1 March he obtains annual insurance on his office building,
starting from 1
March at cost of Rs. 24,000, payable annually in advance.
10 months of the insurance cost relates to the current financial
period (Year 1) and
2 months of it relates to insurance in the next financial year
(January and February Year 2).
The charge to the statement of comprehensive income for insurance
in Year 1 should therefore be Rs. 20,000 (Rs. 24,000 × 10/12).
The prepaid expense for Year 2 is Rs. 4,000 (Rs. 24,000 × 2/12).
Method 2: one
account approach
The
expense in the statement of comprehensive income is Rs. 20,000 and the prepaid
expense is included in the statement of financial position as a current asset
at the end of Year 1.
There is no need to reverse the prepayment using the one
account method as it is already in the expense account at the start of the next
year.
Prepaid expenses: calculating the expense for the statement of comprehensive income
Method 2 requires the calculation of either
the closing prepayment or the charge to the statement of comprehensive income,
the other number being taken as a balancing figure. It is almost always
easier to calculate the prepayment.
The amount charged to the statement of
comprehensive income can be calculated as follows. It is worth spending a
little time trying to understand this.
The expense may also be calculated as follows:
Illustration:
Rs.
Invoices/payments for the year X
+ Opening prepaid expense X
X
– Closing prepaid expense (X)
= Expense for the year X
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