Prepaid expenses: What they are and how to record them

Published

Dec 9, 2024

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Planning and budgeting can feel overwhelming when you don’t have a clear view of your future cash flow. Large, one-time payments only add to the challenge. Prepaid expenses can help by spreading costs over multiple accounting periods, optimizing cash flow, and simplifying the process of balancing the books.

In this article, we’ll dig into how advance payments can benefit businesses and walk through how to account for prepaid expenses on your company balance sheet.

What are prepaid expenses?

Prepaid expenses are costs paid in advance for goods or services a company will receive later. Accounting treats them as current assets because they provide an economic benefit that stretches from the time of payment and into the future. As time passes and the company realizes the benefit, the value shifts to the debit side of the balance sheet and appears as an expense on its income statement.

Example: Widgets.io pays $1,200 in January for an annual subscription to a SaaS product and records a corresponding current asset on its balance sheet. Each month, as part of the reconciliation and closing process, Widgets’ bookkeeper reduces the asset's value by $100 and enters a $100 debit for “Prepaid software licenses.” By the end of the year, the credit associated with the software purchase is zero, while the debit totals $1,200.

Typical prepaid expenses often cover essential operating expenses and can include:

Rent
Insurance premiums
Utilities
Software licenses
Maintenance contracts
Office supplies

Prepaid expenses can cover any product or service that provides a continual benefit over time, but many relate to purchases a business must make in advance. Accident insurance premiums, for example, must be purchased before something goes wrong.

In other cases, a company pays upfront to receive a discount or take advantage of tax deductions. Annual subscriptions for software are often less expensive than paying monthly. Paying annually also allows the business to deduct the entire license cost on its next tax return rather than the amount spent to date.

Example: Acme, Inc. is considering investing in a graphic design tool. The company can pay either a $1,200 annual license or a $150 monthly one. Because Acme isn’t entirely convinced that the tool will meet its needs, it opts for a monthly subscription. In April, the company deducts the $600 spent on the tool to date. The following year, the company purchases an annual subscription and saves $600. It also deducts the entire $1,200 expense from its gross income on its corporate tax return (along with the additional $1,200 spent the previous year).

Where do prepaid expenses appear?

To find prepaid expenses on a balance sheet, start by taking a look at the “Current Assets” heading. Why current assets? Because, in most cases, the business intends to realize the full benefit of its purchase within the following twelve months. Some companies may separate prepaid expenses from more typical current assets like cash and accounts receivable with a separate subheading like “Deferred Charges” or group them under “Other Current Assets.”

However, not all prepaid expenses will appear as current assets. Some may also have corresponding journal entries as long-term, non-current assets, depending on how long it will take for the company to realize the benefit.

Example: On January 1, Big Corp pays $50,000 for a five-year insurance policy. Alex, a staff accountant, records the $10,000 in insurance premiums that applies to the coming year as a current asset and the remaining $40,000 as a long-term asset. At the end of the year, Alex makes an annual adjustment, moving next year’s portion from long-term to current and reducing the value of the long-term asset to $30,000. Alex also records the $10,000 spent the previous year as an expense on Big Corp’s income statement.

Depending on the size of the business and the complexity of its financial statements, you may need to go beyond condensed summaries to find specific information about a prepaid expense.

How to record prepaid expenses in 5 steps

Understanding how and where to record your company’s prepaid expenses not only keeps you compliant with Generally Accepted Accounting Principles (GAAP), it also helps business leaders make sound strategic decisions. For instance, if a company notices a waning cash flow after accounting for prepaid expenses, it might look for opportunities to create liquidity by eliminating or reducing some advance payments.

Organized bookkeeping can streamline the reconciliation process and reduce the risk of error-generating inaccuracies.

Step 1. Identify the prepaid expense

Your first step is determining whether a transaction qualifies as a prepaid expense. Remember, these are transactions a company pays in advance to cover goods or services that the business will receive over a future period, usually twelve months.

Accurate identification prevents misclassification and reconciliation errors, so it’s important to carefully consider the nature of each payment before generating a journal entry. With borderline transactions, it can help focus on the purchase's timing and usage period. If the business won’t benefit until after the company pays, and the benefit crosses multiple accounting periods, you’re probably dealing with a prepaid expense.

Step 2. Record the initial payment on the balance sheet

You’ll usually input prepaid expenses on the balance sheet as current assets. The journal entry reflects both a cash payment and a prepaid expense account creation. You would record the purchase of a $12,000 insurance policy like this, for example:

Debit: Prepaid Insurance (Asset) $12,000

Credit: Cash (Asset) $12,000

Debiting the asset account shows that the company purchased an asset for a particular sum, while crediting the cash account creates a corresponding liability equal to the payment amount.

Step 3. Create adjusting entries

Because the business doesn’t get the benefit of its purchase all at once, you’ll need to create adjusting entries to allocate the expense over time. How frequently you prepare adjusting entries depends on the number of periods over which you intend to distribute or amortize the cost of the benefit.

Start by calculating the portion of the prepaid expense that applies to a particular period. To do this, divide the total prepaid amount by the number of amortization periods. Let’s say your business follows a quarterly accounting cycle. Divide $12,000 by four and allocate $3,000 to each quarter.

Next, reduce the prepaid asset account and increase the expense account for each period. Each quarter, you would enter a debit of $3,000 to reflect the expense and a matching credit to the prepaid insurance asset:

Debit: Insurance Expense (Expense) $3,000

Credit: Prepaid Insurance (Asset) $3,000

Step 4. Record expenses on the income statement

At the same time that you make an adjusting entry, update the income statement to reflect the consumption of the prepaid expense. In the case of the $12,000 insurance policy, you’ll record a $3,000 expense on the income statement each quarter once you’ve entered the debit on the balance sheet.

Step 5. Repeat the process

Continue the cycle of steps one through four until the business fully realizes the benefit it purchased. You’ll know you’ve reached this point when the balance of the prepaid asset account equals $0.

If your business follows an annual accounting cycle, you may want to add verifying journal entries for prepaid expenses to your year-end accounting checklist to smooth the reconciliation and closing process.

Prepaid expenses examples

To better understand how a business benefits from and documents a prepaid expense, let’s consider two hypotheticals.

Hypothetical 1: Big Corp. pays $240,000 on January 1 for a three-year equipment maintenance contract. Taylor, a junior accountant, records the payment. Taylor allocates $80,000 to the current year as a current asset and the remaining $16,000 to long-term assets.

Debit: Prepaid Maintenance (Current Asset) $80,000

Debit: Prepaid Maintenance (Non-Current Asset) $160,000

Credit: Cash (Asset) $240,000

At the end of the year, Taylor creates two new entries. One is an adjusting entry that recognizes the current expense:

Debit: Maintenance Expense (Expense) $80,000

Credit: Prepaid Maintenance (Current Asset) $80,000

The second entry moves the second year’s cost from long-term assets to current assets:

Debit: Prepaid Maintenance (Current Asset) $80,000

Credit: Prepaid Maintenance (Non-Current Asset) $80,000

Hypothetical 2: Small Biz, LLC makes a $12,000 payment to a digital marketing agency in January for a six-month ad campaign. Morgan, the company’s financial controller, creates a new journal entry for the prepaid expense:

Debit: Prepaid Marketing (Asset) $12,000

Credit: Cash (Asset) $12,000

For the next six months, Morgan recognizes the $2,000 of services Small Biz receives in an adjusting entry and creates a matching expense on the income statement. By the end of June, Small Biz’s balance sheet includes Morgan’s initial entry and six identical adjusting entries like this:

Debit: Marketing Expense (Expense) $2,000

Credit: Prepaid Marketing (Asset) $2,000

The best expense management tool

An ad-hoc expense management system complicates your finance team’s ability to gauge cash flow and monitor prepaid expenses.

Rippling consolidates all of your company’s finances—from payroll and benefits to corporate cards and expense management–giving you an up-to-date view of inflows and outflows across your company and offering unprecedented control over business spend. While most expense management tools can save companies time and simplify the employee reimbursement process, they typically aren’t connected with the rest of your company’s finance systems. In Rippling, you can manage expense reimbursements alongside vendor bills, payroll, and corporate cards on one intuitive platform.

Efficient expense management also prepares companies for audits. When expense claims, receipts, and reimbursements are neatly organized and recorded in a general ledger and other accounting systems, companies have compliant documentation at the ready if the IRS or other regulatory agencies come knocking.

With Rippling you can:

Automatically route expenses and bills to the right approver every time.
Flag out-of-policy spending with hyper-custom policies, like by vendor or value, for further review.
Close the books faster with AI-powered transaction categorization and integration with your accounting systems.

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Prepaid expenses FAQs

What is the journal entry for prepaid expenses?

The journal entry for prepaid expenses is debited to the prepaid expense account under current assets and credited to cash payments or accounts payable accounts when payment is made. Each month, an adjusting entry realizes the portion spent as an expense with a corresponding credit to the prepaid expense account.

What is the difference between accrued expenses and prepaid expenses?

The difference between accrued expenses and prepaid expenses lies in timing and classification. Accrued expenses are costs a business has already incurred but still needs to pay. They’re recorded as liabilities on the balance sheet. Prepaid expenses are advance payments made for a future benefit and are recorded as assets. One reflects an obligation already owed, while the other refers to value not yet realized.

How do you record prepaid expenses in financial statements?

You record prepaid expenses as assets on the company’s balance sheet at the time of payment. Over time, as the company consumes the benefit, you’ll transfer a portion from the prepaid account to the corresponding expense account in the income statement. Matching the costs to the period in which they apply helps ensure accurate expense recognition.

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