Loading the player...

What is a 'Prepaid Expense'

A prepaid expense is a type of asset that arises on a balance sheet as a result of business making payments for goods and services to be received in the near future. While prepaid expenses are initially recorded as assets, their value is expensed over time as the benefit is received onto the income statement, because unlike conventional expenses, the business will receive something of value in the near future.

BREAKING DOWN 'Prepaid Expense'

Due to the nature of certain goods and services, there must be prepaid expenses. For example, insurance is a prepaid expense, because the purpose of purchasing insurance is to buy proactive protection in case something unfortunate happens. Clearly, no insurance company would sell insurance that covers the occurrence of an unfortunate event after the fact, so insurance expenses must be prepaid.

An example of expensing prepaid expenses would be if a company had a one-year insurance policy cost of $1,200. As each month elapses, $100 of prepaid insurance would be expensed to the income statement until the account is empty at the end of the year.

Recording Prepayments

Companies make prepayments for goods or services such as equipment or insurance coverage that provide continual benefits over time. Goods or services of this nature cannot be expensed immediately and entirely as a cost to revenue on the income statement in one single accounting period and must be recorded instead as assets on the balance sheet at the time of their purchases before being used or consumed. To record a prepayment, debit the equipment or insurance policy account, and credit the cash account, assuming no trade credit is used. This effectively increases the amount in the prepaid-expense asset account and reduces the cash balance.

Matching Expenses

The matching principle in accounting requires expenses be matched with revenues at the time an expense makes its contribution to revenue. In other words, expenses are recognized not necessarily when related payments are made but when the benefits from the expenses can be tied to the expected revenues. For example, as a piece of equipment depreciates after being deployed in use, periodic depreciation cost is recognized as an expense for each accounting period when the use of the equipment is actually contributing to each period's revenue generation. The approach to matching expenses is letting the expenses follow the revenues.

Adjusting Entries

Journal entries used to record the recognition of expenses related to prior prepayments are called adjusting entries, which do not record new business transactions but simply adjust certain previously recorded transactions. Adjusting entries for prepaid expenses are needed to ensure that expenses are recognized in the period in which they are incurred. To record the adjusting entries for a prepayment at the end of an accounting period, debit the related, actual expense account to denote the expense recognition, and credit the asset account of the prepaid expense to reduce its outstanding balance. This process repeats until the prepaid expense is fully expensed over time.

RELATED TERMS
  1. Adjusting Journal Entry

    An adjusting journal entry occurs at the end of a reporting period ...
  2. Deferred Charge

    A prepaid expense that is treated as an asset on a balance sheet ...
  3. Advertising Costs

    Advertising costs are a category in financial accounting that ...
  4. Accrued Expense

    An accounting expense recognized in the books before it is paid ...
  5. Variable Prepaid Forward Contracts

    Variable prepaid forward contracts are synthetic investment strategies ...
  6. Prepaid Finance Charge

    A prepaid finance charge is an upfront charge associated with ...
Related Articles
  1. Personal Finance

    The Last States With Prepaid Tuition Plans

    Prepaid tuition could save you thousands of dollars and unwanted stress. Find out where you can still find them.
  2. Personal Finance

    6 Reasons You Don't Need A Prepaid Debit Card

    We'll look at six situations where a prepaid debit card might seem like a good idea, but it really isn't necessary.
  3. Taxes

    Avoid The Prepaid Tax Refund Debit Cards

    Here are reasons why you shouldn't get a prepaid card from TurboTax, Jackson Hewitt, TaxAct or H&R Block.
  4. Financial Advisor

    Pay Attention To Your Fund’s Expense Ratio

    Despite trends indicating an overall decrease in fees across many fund categories, investors should still pay attention to expense ratios: even small differences in fees can have a significant ...
  5. Investing

    Top 8 Ways Companies Cook the Books

    Find out more about the fraudulent accounting methods some companies use to fool investors.
  6. Personal Finance

    The Dangers of Getting a Paycheck on a Prepaid Debit Card

    Receiving your paycheck on a prepaid debit card may seem like a boon until you discover all the fees that can come with it.
  7. Taxes

    Deferred Tax Asset

    A Deferred Tax Asset is an asset on a company’s balance sheet that may be used to reduce taxable income. It is the opposite of a deferred tax liability, which describes something that will increase ...
RELATED FAQS
  1. How are prepaid expenses recorded on an income statement?

    Understand how prepaid expenses are recorded on a company's financial statements. Learn why a prepaid expense would be considered ... Read Answer >>
  2. Who benefits the most from prepaid expenses?

    Learn who benefits most when expenses are prepaid. Individuals and businesses often make payments, such as rent or insurance, ... Read Answer >>
  3. What is the difference between an operational expense and an administrative expense?

    An operating expense covers the production and marketing of products and services, whereas an administrative expense covers ... Read Answer >>
  4. Is it possible for a company to have a positive cash flow and a negative net income?

    This situation may seem a bit counter-intuitive at first, but it is actually quite common and not too difficult to understand. ... Read Answer >>
  5. What are general and administrative expenses?

    General and administrative expenses are not directly attributable to the production of goods and services and include audit ... Read Answer >>
  6. Why are capital expenses (CAPEX) treated differently than current expenses?

    Learn the difference between capital expenditures, or CAPEX, and current expenses, and determine why they are treated differently ... Read Answer >>
Hot Definitions
  1. Net Present Value - NPV

    Net Present Value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows ...
  2. Price-Earnings Ratio - P/E Ratio

    The Price-to-Earnings Ratio or P/E ratio is a ratio for valuing a company that measures its current share price relative ...
  3. Internal Rate of Return - IRR

    Internal Rate of Return (IRR) is a metric used in capital budgeting to estimate the profitability of potential investments.
  4. Limit Order

    An order placed with a brokerage to buy or sell a set number of shares at a specified price or better.
  5. Current Ratio

    The current ratio is a liquidity ratio that measures a company's ability to pay short-term and long-term obligations.
  6. Return on Investment (ROI)

    Return on Investment (ROI) is a performance measure used to evaluate the efficiency of an investment or compare the efficiency ...
Trading Center