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The model calculates monthly amortization for prepaid expenses and/or unearned income, generating relevant accounting entries.
Prepaid expenses represent expenditures that have been paid for in advance but have not yet been recorded as an expense. In other words, prepaid expenses are expenditures paid in one accounting period that will be recognized in a later accounting period. Prepaid expenses are initially recorded as assets, because they have future economic benefits, and are expensed at the time the benefits are realized (the matching principle).
The two most common examples of prepaid expenses are rent and insurance.
Prepaid income is revenue received in advance but not yet earned. Income must be recorded in the accounting period it is earned. Therefore, prepaid income is not shown as income in the accounting period it is received but in the subsequent accounting periods in which the respective services or obligations have been performed.
An entity should therefore recognize a liability in respect of income received in advance until such time as the obligations or services that are due on its part in relation to the prepaid income have been performed.
Examples of income received in advance are rent and commissions received in advance.
Company ABC pays a $12,000 insurance premium for the upcoming year. The company pays for the policy upfront and then each month makes an adjusting entry to account for the insurance expense incurred. The initial entry, where we debit the prepaid expense account and credit the account used to pay for the expense, would look like this:
Jan. 1, 2020 Debit Prepaid Insurance $12,000
Credit Cash $12,000
Then, after a month, the company makes an adjusting entry for the insurance used. The company makes a debit to the appropriate expense account and credits the prepaid expense account to reduce the asset value. The monthly adjustment for Company ABC would be $12,000 divided by 12 months, or $1,000 a month. The adjusting entry at the end of each month would appear as follows:
Feb. 1, 2020 Debit Insurance Expenses $1,000
Credit Prepaid Insurance $1,000
Similar entries, with opposite sign, should be posted for unearned income.