Prepaid expense
A cost paid in advance for goods or services the business will use in future periods, held as an asset until it is used up.
In short
- Annual insurance, software subscriptions and rent paid ahead are typical examples.
- The payment is recorded as an asset, then expensed period by period.
- Small prepaid amounts are often expensed immediately under a materiality policy.
A prepaid expense is money paid before the related benefit is received. When a business pays a full year of insurance in January, it has not yet used eleven months of that coverage. Under accrual accounting, the unused portion is an asset, and it becomes an expense as each month passes.
How it is recorded
The payment is recorded as a prepaid asset on the balance sheet. At the end of each period, an adjusting entry moves the portion that has been used up to the income statement. A $24,000 annual software subscription paid on January 1 becomes $2,000 of expense each month, and the prepaid balance falls to zero by December 31.
Common prepaid expenses
- Insurance premiums
- Annual software and SaaS subscriptions
- Rent paid in advance
- Maintenance and support contracts
- Deposits on trade shows or events in a future period
Keeping track
Businesses usually keep a prepaid schedule listing each item, its start and end date and the amount to expense each month. Without one, prepaid balances drift: an annual payment expensed in full in the month it was paid distorts that month, and an asset left on the balance sheet after the service has ended overstates assets. Many companies set a threshold, such as $2,500, below which prepayments are simply expensed.
Worked example
An annual subscription
On April 1, a company pays $9,600 for a 12-month subscription to its accounting software. It records a $9,600 prepaid asset and expenses $800 each month. On September 30, after six months, the prepaid balance is $4,800 and $4,800 has been expensed.