The profit earned by an entity is determined through the profit and loss account. All the expenses are recorded on the debit side of the profit and loss account while all the incomes are recorded on the credit side.

The profit is shown as the credit balance of profit and loss A/c. When the sum of items on the debit side of a profit and loss account is less than the sum of those on the credit side, it implies profit while when the sum of the items on the credit side is less than the sum of those on the debit side, it implies a loss for the entity.

The Reason for Credit

Profit is recorded as an increase in equity

To understand the reason why profit is recorded as a credit balance, we must first understand the basic principle of debit and credit.

The basic principle of debits and credits is that debits increase asset accounts and decrease liability and equity accounts while credits decrease asset accounts and increase liability and equity accounts.

The revenue that a company earns is credited to the income account and increases equity.

The expenses that a company incurs to earn that revenue are debited to the expense account and decrease equity.

The difference between revenue and expenses is the profit, which is recorded as an increase in equity.

Increase in equity due to revenue – decrease in equity due to expense = profit

Gross Profit Vs Net Profit

Revenue is the total income that a business or profession earns. Profit is the excess revenue that remains after reducing all expenses from it.

Gross profit is the profit that a company earns after reducing the cost of goods sold from sales revenue while net profit is the profit that a business earns after reducing the total of all its direct and indirect expenses from its direct as well as indirect allowable business income.

Conclusion

The basic principle of debit and credit governs the classification of profit as a debit or credit. Since profit increases our equity, it is a credit.

In the case of a company, it belongs to the shareholders. It is usually recorded in the retained earnings account. Profit can be reinvested in the business or can be distributed as a dividend. In the case of a sole proprietorship, the profit belongs to the owner and is recorded in the owner’s capital account.

Prepaid expense means a service to be rendered in the future period for which the business has already paid the remuneration. Prepaid expenses are classified as assets. The benefits of this payment will accrue to the business at a later period. 

For example, insurance is often paid for annually on the basis of the calendar year. A business may pay insurance every year on 1st January for that entire year. While preparing the financial statements on 31st March, it will recognize the insurance premium for the period 1st April to 31st December of the next financial year as a prepaid insurance expense. 

Why are prepaid expenses classified as assets? 

First of all, let us understand what an asset is. An asset is anything over which the business has ownership rights and which it can sell for money. The benefits of this asset should accrue to the business. 

In light of this definition, let us analyze prepaid expenses as an asset. As the business has already paid for these goods or services, it becomes a legal right of the business to receive the relevant goods or services at a later date. As the benefit of this expense would accrue to the business only at a later date, the prepaid expenses are classified as an asset. 

Some examples of prepaid expenses are prepaid insurance, prepaid rent etc

Treatment of Prepaid Expenses

Prepaid expenses are recorded in the balance sheet under the heading “Current Assets” and sub-heading “Other Current Assets”

As per the Generally Accepted Accounting Principles or GAAP, expenses must be recognized in the accounting period to which they relate or in which the benefit due to them is likely to arise. Thus, we cannot recognize the prepaid expenses in the accounting period in which they are incurred. 

Prepaid assets are classified as assets and carried forward in the balance sheet to be debited in the income statement of the accounting period to which they relate. 

Adjusting Entries

Adjusting entries are those entries that are used to recognize prepaid expenses in the income statement of the period to which they relate. These entries are not used to record new transactions. They ensure compliance with GAAP by recognizing the expenses in the period to which they relate. 

Conclusion

The GAAP and basic definition of an asset govern the treatment of prepaid expenses as an asset. The business incurs them in an accounting period different from the accounting period in which their benefit would accrue to the business. The business has a legal right to receive those goods or services. 

The business carries them as a current asset on the balance sheet. In the relevant accounting period, they are recognized in the income statement.