You paid for a year of insurance in January. If you record the whole payment as January’s expense, January looks terrible and the other 11 months look better than they are.
Prepaid expense accounting fixes that. Here’s how it works, with journal entries and a schedule you can follow.
What Are Prepaid Expenses?
A prepaid expense is a payment for goods or services you’ll receive in a future period. It’s recorded as an asset when you pay, then moved to expense as you use it.
Prepaid expenses follow the matching principle: expenses belong in the period they help generate revenue, not the period you happened to pay.
Common Prepaid Expenses
- Insurance premiums
- Rent paid in advance
- Annual software subscriptions and licenses
- Maintenance and service contracts
- Advertising paid before it runs
- Retainers paid to attorneys or consultants
- Property taxes paid in advance
One that’s often confused: security deposits aren’t prepaid expenses. You expect to get a deposit back, so it’s recorded as a separate asset and never becomes an expense.
How to Record a Prepaid Expense
Prepaid expense accounting takes two steps.
Step 1: Record the Payment as an Asset
When you pay, debit the prepaid asset account and credit cash.
Step 2: Move It to Expense Over Time
At the end of each period, usually monthly, debit the expense account and credit the prepaid asset for the portion you used. This is an adjusting entry, and it’s called amortizing the prepaid.
New to debits and credits? Read Journal Entries Explained With Examples.
Prepaid Expense Examples
Example 1: Prepaid Insurance
On January 1, a business pays $6,000 for a 12-month insurance policy.
On January 1:
| Account | Debit | Credit |
|---|---|---|
| Prepaid Insurance | $6,000 | |
| Cash | $6,000 |
At the end of each month ($6,000 ÷ 12):
| Account | Debit | Credit |
|---|---|---|
| Insurance Expense | $500 | |
| Prepaid Insurance | $500 |
Example 2: Prepaid Rent
On October 1, a business pays three months of rent in advance: $9,000, or $3,000 a month.
On October 1:
| Account | Debit | Credit |
|---|---|---|
| Prepaid Rent | $9,000 | |
| Cash | $9,000 |
At the end of October, November and December:
| Account | Debit | Credit |
|---|---|---|
| Rent Expense | $3,000 | |
| Prepaid Rent | $3,000 |
Example 3: Annual Software Subscription
On July 1, a business pays $2,400 for a one-year software subscription.
On July 1:
| Account | Debit | Credit |
|---|---|---|
| Prepaid Software | $2,400 | |
| Cash | $2,400 |
At the end of each month ($2,400 ÷ 12):
| Account | Debit | Credit |
|---|---|---|
| Software Expense | $200 | |
| Prepaid Software | $200 |
Prepaid Expense Amortization Schedule
An amortization schedule shows how much expense you recognize each month and what’s left in the prepaid account. Here’s the schedule for the $6,000 insurance policy in Example 1:
| Month | Monthly expense | Prepaid balance remaining |
|---|---|---|
| January | $500 | $5,500 |
| February | $500 | $5,000 |
| March | $500 | $4,500 |
| April | $500 | $4,000 |
| May | $500 | $3,500 |
| June | $500 | $3,000 |
| July | $500 | $2,500 |
| August | $500 | $2,000 |
| September | $500 | $1,500 |
| October | $500 | $1,000 |
| November | $500 | $500 |
| December | $500 | $0 |
| Total | $6,000 |
Keep one schedule for every prepaid. At month-end, the remaining balances on your schedules should match the prepaid accounts on your balance sheet.
Prepaid Expenses vs. Accrued Expenses
They’re opposites, and both are adjusting entries.
| Prepaid expense | Accrued expense | |
|---|---|---|
| Timing | You pay before you use it | You use it before you pay |
| Recorded as | An asset | A liability |
| Example | Annual insurance paid in January | Utilities used in March, billed in April |
| Adjusting entry | Debit expense, credit prepaid asset | Debit expense, credit accrued liability |
| Clears when | The benefit is used up | You pay the bill |
How Prepaid Expenses Affect Your Financial Statements
On the balance sheet, a prepaid expense starts as an asset. Prepaids you’ll use within 12 months are current assets. Any portion that extends beyond 12 months is a noncurrent asset.
On the income statement, the expense appears gradually, one period at a time, as you use the benefit.
Get it wrong, and both statements are off. Expensing a full year at once understates profit in the month you pay and overstates it in the months after. Forgetting to amortize overstates your assets.
Prepaid Expenses Across Different Businesses
| Business type | Common prepaids | How they’re typically recognized |
|---|---|---|
| Retail | Rent, insurance, property taxes | Rent and insurance monthly; property taxes over the period they cover |
| Service businesses | Software subscriptions, advertising, professional retainers | Over the subscription term, or as services are delivered |
| Manufacturing | Insurance, maintenance contracts | Insurance monthly over the coverage period; maintenance over the contract term |
Common Challenges and Best Practices
Challenges
- Choosing the right period: the amortization period should match the term of the benefit
- Tracking many schedules: every policy, lease and subscription needs its own
- Missed adjusting entries: when month-end gets busy, amortization is easy to skip
Best Practices
- Keep an amortization schedule for every prepaid
- Reconcile prepaid balances to your schedules every month
- Set a materiality threshold. Many businesses expense small prepaids immediately rather than tracking them.
- Use your accounting software’s recurring journal entries to automate amortization
- Write down your policy, so everyone records prepaids the same way
A note on taxes: tax rules for deducting prepaid expenses can differ from how you record them on your books. Ask your CPA how they apply to your business.
Prepaid Expenses FAQ
Is a prepaid expense an asset?
Yes. A prepaid expense is an asset, because you’ve paid for a future benefit you haven’t used yet. It becomes an expense as you use it.
Where do prepaid expenses go on the balance sheet?
Prepaids used within 12 months are current assets. Any portion beyond 12 months is a noncurrent asset.
What’s the journal entry for a prepaid expense?
When you pay, debit the prepaid asset and credit cash. Each period, debit the expense and credit the prepaid asset for the portion used.
What’s the difference between a prepaid expense and an accrued expense?
A prepaid expense is paid before you use it and recorded as an asset. An accrued expense is used before you pay it and recorded as a liability.
Are security deposits prepaid expenses?
No. Deposits you expect to get back are recorded as a separate asset, not a prepaid expense.
Let a Bookkeeper Handle the Schedules
Prepaid expenses are easy to record and easy to forget. BELAY’s U.S.-based bookkeepers keep your amortization schedules current and your books reconciled every month. Need more? Explore BELAY Financial Solutions, including controller and CFO support.
Related reading: How Much Does a Bookkeeper Cost? | What Is Fractional Accounting? | Bookkeeping 101: Basics for Beginners
