Accruals and Prepaid Expenses Dilemma?
Suresh has purchased a one-year insurance policy for his business on January 1st. He has paid the premium in lump sum, which involves an annual premium of ₹ 15000. However, the policy period is from January 1st to December 31st, with January and February being the first two months of the policy. How should Suresh record the accounting entry for the prepaid insurance?
1 Answer
📌 CONCEPT: Accruals and prepaid expenses are recorded when they are earned or used, not when they are paid or received.
📐 RULE / FORMULA: The matching principle states that expenses should be matched with revenues in the same accounting period, and prepaid expenses should be amortized over the period they are used.
💡 WORKED EXAMPLE: Suresh pays ₹ 15000 for a one-year insurance policy on January 1st. In the first month (January), he has earned 1/12 of the insurance, so he will debit 'Prepaid Insurance' by ₹ 1250 and credit 'Expenses' by the same amount. In the next month (February), he will debit 'Expenses' by ₹ 1250 and credit 'Prepaid Insurance' by ₹ 1250, until the prepaid insurance is fully utilized.
⚠️ COMMON MISTAKE: Students often forget to amortize prepaid expenses over the period they are used, leading to incorrect recording of expenses.
02 Oct 26
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