When creating a budget, how should fixed expenses such as prepaid rent be recorded in the accounting system?

• A. Record the entire prepaid amount as an expense immediately.
• B. Record prepaid expenses as liabilities until paid.
• C. Do not record prepaid expenses until the service is fully consumed.
• D. Record the entire prepaid amount as an asset and expense it over time as it is used.

Answer: (D)

Verified step by step guidance

1. Understand the nature of prepaid expenses: Prepaid expenses are payments made in advance for goods or services that will be consumed in the future. Examples include prepaid rent, insurance, or subscriptions.
2. Classify prepaid expenses correctly: Prepaid expenses are considered assets because they represent future economic benefits. They should not be recorded as expenses immediately upon payment.
3. Record the initial payment: When the prepaid expense is made, record the entire amount as an asset in the accounting system. For example, debit the 'Prepaid Rent' account and credit 'Cash' or 'Bank' to reflect the payment.
4. Expense the prepaid amount over time: As the service or benefit is consumed (e.g., each month of rent), transfer the appropriate portion of the prepaid amount from the asset account to an expense account. This is done using an adjusting journal entry.
5. Ensure compliance with the matching principle: The matching principle in accounting requires that expenses be recognized in the same period as the revenues they help generate. By expensing prepaid amounts over time, you align the expense recognition with the period of benefit.