In practice, small business made one lump sum prepayment or downpayment for purchases or services accross a certain period. For instance, the business may entered into insurance contract to insure its asset for a period of 12 months.
From accounting perspective, the amount prepaid should be expensed over the period of servie covered. To illustrate, the 12-month insurance premium paid should be expensed off over a period of 12 months. What would be the accounting treatment then?
Assuming Company XYZ entered into insurance contract to insure its inventory. Total insurance premium paid is US$12,000.
Upon payment of insurance, the Company passed the following entries:
Dr. Prepayment (B/S- Asset)12,000
Cr. Cash 12,000
(Being prepayment to insurer for insurance contract)
At month end, the following entry will be passed to recognise the insurance expense
Dr. Insurance expense (P/L)1,000 (12,000/ 12)
Cr. Prepayment 1,000
(Being utilisation of monthly insurance expense)
At the end of 12 months, the prepayment accounted will be fully utilised.