The term “prepaid expense” denotes something that has been paid for in advance by a company, but not yet incurred. Businesses record prepaid expenses as assets on their balance sheet because they encompass goods or services that will be received at some point in the future. Although they are recorded as assets, prepaid expenses are expensed over time on the income statement because, in most cases, the prepaid expense will result in the company receiving something of value over several accounting periods.

Common Prepaid Expenses Incurred by Businesses

Prepaid expenses take many forms with some of the most common being:

Insurance: Insurance is perhaps the most common (or at least the most well-known) type of prepaid expense. Companies shell out huge amounts of money on various insurance policies that may never be invoked. If something does happen, however, any and all premium payments must be current before the insurance company will even consider a claim.

Rent: Businesses often lease additional office or warehouse space in anticipation of future growth. Such expenses are a classic example of prepaid expenses since the business is obligated to pay a portion of the rent (typically one or two months’ worth of the agreed rental amount) at the time the lease agreement is signed, even though it may be many months before the company moves into the space.

Software subscriptions: In many cases, software vendors will provide significant discounts if a company prepays the entire amount of the contract upfront. The type of software that is most often associated with a prepaid expense is Software as a Service, or SaaS.

Cleaning contracts: Like software providers, cleaning companies will sometimes offer substantial discounts if a company pays the full contract price up front. This is another classic prepaid expense in that at least some of the service you pay for today will not be received for weeks, months or even years in the case of a multi-year contract.

Legal retainers: Any business of sufficient size needs to have access to quality legal representation. In order to ensure that’s the case, companies will often pay large retainers as a way of “reserving” a law firm’s services. As a result, should a problem arise the company will get full and immediate attention from the law firm. 

Recording Prepaid Expenses

The following are the steps companies normally take to record prepaid expenses.

Step 1: Make the payment

Nothing happens from an accounting standpoint until payment is made for the prepaid expense. Once payment occurs, it must be marked on the company’s balance sheet as an asset. Why? Because it represents a benefit the company will receive at some point in the future.

Step 2: Make the entry into the accounting journal

Once payment is complete, an entry must be made in the company’s general accounting journal that reflects the payment. This entry will mark the beginning of the accounting process for the expense and establishes the expectation of goods or services to be received down the line.

Step 3: Debit the asset account

When making the initial record of the prepaid expense, credit the asset account for the full amount and then debit the company’s cash account. For example, if the prepaid expense is $5,000, add $5,000 in the assets account and deduct $5,000 from the cash account.

Step 4: Expense a portion at the end of each accounting period

Expense a portion of the total prepaid expense at the end of each accounting period during which the company benefits from the product or service. Over time, this will reduce the balance of the prepaid asset account and transform it into an expense.

Summary

A prepaid expense indicates something a company has paid for in advance, but the expense has not yet been incurred. Examples of prepaid expenses include insurance, rental property, software subscriptions and legal retainers. Initially recorded as assets, prepaid expenses are eventually transformed into expenses over the course of the period during which the company benefits.

It is good practice not to record small prepaid expenditures into the prepaid expense account simply because tracking them over time takes too much effort relative to their overall value. Charge such small payments instead to expense as they are incurred.