Sometimes, a business makes payments of certain expenses in advance. These expenses are known as prepaid expenses. In short, these are the expenses the benefits of which have not been availed but the payment is already made in advance. It basically represents the advance payments made during the current year relating to the next accounting year.
For example, an insurance premium of Rs 12,000 was paid on June 30, 2013, for one year. The accounting year starts from 1st April 2013 till 31st March 2014. In this case, during the year 2013 insurance premium is paid only for 9 months (i.e. from July 2013 to March 2014) which is related to the current year 2013-14. The rest of the part of the payment for the remaining 3 months (i.e. from April 2014 to June 2014) will be regarded as insurance paid in advance for the year 2014-15. Therefore, the amount of Rs 3,000 is considered prepaid insurance.
When Prepaid Expenses are given outside the Trial Balance
Generally, the information related to the prepaid expenses is given outside the Trial Balance.
Treatment of Prepaid Expenses in the financial statements
First of all, prepaid expenses are shown on the Debit side of the Trading or Profit and Loss Account as a deduction from the related expense.
Secondly, it is shown on the Assets side of the Balance Sheet under the head Current Assets. It is considered an asset because the benefits against these expenses are not yet availed.
When Prepaid Expenses are given Inside the Trial Balance
There may be a situation when prepaid expenses are given inside the Trial Balance. In such a case, these expenses are already adjusted in the concerning expenses. Therefore, there is no need to show them in the Profit and Loss Account. These are shown only in the Balance Sheet.
Operating Profit can be defined as the profit earned by carrying the normal business activities. It is computed by subtracting the operating expenses from the gross profit.
The balance sheet is the last financial statement that is prepared by any organization. This statement helps to ascertain the true financial position of an enterprise at the end of an accounting period
A profit and Loss Account is the second financial statement prepared by an organization. This account is prepared to ascertain the net results of a firm in form of net profit earned or net loss incurred during an accounting period.
In order to incorporate adjustments in the financial statements, we pass the required Journal entries, which are termed as adjusting entries.