What is a prepaid expense and how is it adjusted?

• A. A payment for expenses before they are incurred; initially asset; adjust by recognizing expense and reducing asset (Debit Expense; Credit Prepaid Expense).
• B. An expense that is recognized immediately; no asset involved.
• C. A liability for future expenses; adjust by increasing expense.
• D. A revenue item that is recognized when cash is received.

Answer: (A)

A prepaid expense is money paid in advance for goods or services you will receive in the future. Because you’ve paid for something that hasn’t fully been consumed yet, it sits on the balance sheet as an asset (a prepaid asset). As time passes and the benefit is used, you move the appropriate portion to expense and reduce the asset. The adjusting entry is to debit the expense account and credit the prepaid asset account. For example, if you pay for a year of insurance upfront, you record it as Prepaid Insurance (an asset). Each month, you adjust by debiting Insurance Expense and crediting Prepaid Insurance for that month’s portion.

This understanding fits the idea that prepaid expenses are assets that become expenses over time. They are not recognized as an immediate expense, they are not liabilities, and they are not revenues.