Chapter 2
Linking Personal Accounting to Business Accounting
37
Pay Cash before the Expense is Incurred
When a company pays before the expense has been incurred, this is a supplier prepayment. This
scenario requires increasing an asset account called a prepaid expense, which was discussed in the
context of personal accounting.These prepayments are not considered an expense at the time they
are paid because the service or the product has not been used.
For example, if a company pays its insurance premiums one year in advance, it is paying for services
not yet received. The premiums should only be expensed in the months to which they apply—
hence they are called prepaid expenses. Other common examples of prepaid expenses are rent and
office supplies, although any time a company pays for products or services in advance, they can be
considered prepaid expenses.
A business paid cash ahead of time to the insurance company for insurance coverage to be provided
for the upcoming year. At the time of the payment, cash decreases and a prepaid expense called
prepaid insurance increases.This prepaid expense is considered an asset because it could be turned
back into cash if the entire year of insurance is not used up (e.g. the policy is cancelled).
The business paid$3,600 for insurance on January
1, 2016 for insurance coverage throughout 2016.
On January 1, 2016, when the payment is made,
the business’ cash (an asset) decreases by $3,600
and prepaid insurance (another asset) increases
by $3,600. At this point, equity is not affected.
One asset was exchanged for another asset.This
is shown in Figure 2.13.
Notice that expenses, and thus equity, have not
been affected yet. Only as the asset is used up
will an expense be recorded. If the insurance
company fails to provide the services, or the busi-
ness cancels the policy, the insurance company
would have to return cash to the business for the
unused portion of the policy. In this example, as
each month passes, the prepaid insurance will
gradually become an expense.The details for this
transaction will be covered in a later chapter.
2
ASSETS
BALANCE SHEET
LIABILITIES
OWNER’S EQUITY
CASH
ACCOUNTS
RECEIVABLE
PROPERTY, PLANT
& EQUIPMENT
PREPAID
INSURANCE
OFFICE
SUPPLIES
ACCOUNTS
PAYABLE
UNEARNED
REVENUE
BANK
LOAN
OWNER’S
CAPITAL
OWNER’S
DRAWINGS
- $3,600
+ $3,600
The company now owns a
one year insurance policy
No change in owner’s equity
Prepay an expense
______________
FIGURE 2.13
