Prepaid expenses: definition, examples and journal entries

Prepaid expenses are payments made before the goods or services they cover are received. They’re recorded as an asset first, then moved to expense as the benefit is used.

This guide explains how to record and amortize prepaid expenses, with a worked schedule, and how they affect the balance sheet, financial ratios, and taxes. Spreading a prepaid cost over the periods it benefits keeps each month’s results accurate.

What are prepaid expenses?

Prepaid expenses are payments made in advance for goods or services a business will receive or use in a later period, and they’re sometimes called deferred expenses. They’re recorded as assets on the balance sheet, because they represent a future benefit the business has already paid for. As the goods or services are used, the cost moves to the income statement as an expense.

Common examples include insurance premiums, rent, software subscriptions, maintenance and service contracts, and advertising paid before a campaign runs.

The portion that will be used within 12 months, or within the operating cycle if that’s longer, is a current asset. Any longer-term portion is a non-current asset, and it moves to current as the time to use it gets closer.

How do prepaid expenses work?

Prepaid expenses separate when a business pays from when it records the expense. At payment, the cost goes to a prepaid asset account. At the end of each period, an adjusting entry moves the portion used from the asset to expense, a process called amortization. That way, the expense lands in the same period as the benefit, which is the matching principle at work.

For example, say a company pays $6,000 upfront for a 12-month software subscription. It records a $6,000 prepaid asset, then expenses $500 each month ($6,000 ÷ 12). After six months, $3,000 has been expensed, and $3,000 remains on the balance sheet. This example is illustrative.

Why are prepaid expenses important?

Prepaid expenses put costs in the periods that benefit from them. A large annual payment recorded all at once would overstate expenses in one month and understate them for the rest of the year. Spreading it out keeps monthly results comparable and makes budgeting and forecasting more reliable.

Prepaying can also save money when a vendor offers a discount for paying upfront. It doesn’t improve cash flow, though, because the cash leaves the business at payment. The benefit is accurate expense timing and, sometimes, a lower price.

Benefits of prepaid expenses

The main benefits are accurate statements, easier planning, and price certainty.

• Accurate financial statements: Expenses land in the periods they benefit, so reported results line up with the revenue those costs help produce.
• Better budgeting and forecasting: A schedule of prepaid balances shows future expenses ahead of time, which makes planning easier.
• Predictable costs: Paying upfront can lock in a price for the full term and replace several payments with one. Cash still leaves at payment, so the benefit is price certainty, not extra cash on hand.

Downsides to prepaid expenses

Prepaying carries three main risks.

• Less available cash: Paying in advance ties up cash the business could use elsewhere.
• Obsolescence: A prepaid service or item can stop being useful before the term ends.
• Vendor non-performance: If a vendor doesn’t deliver, recovering the payment can be slow and uncertain.

If a prepayment is non-refundable and the benefit is never received, the remaining balance becomes a loss.

Journal entries for prepaid expenses

The journal entry for a prepaid expense depends on the method you use: the asset method or the expense method. Choose one and apply it consistently. Once the period-end adjusting entry is made, both methods produce the same financial statements.

Asset method

Under the asset method, you record the payment as an asset and expense it over time.

• At payment: debit Prepaid expense, and credit Cash or Accounts payable.
• Each period: debit the expense account, and credit Prepaid expense for the portion used.

Expense method

Under the expense method, you record the full payment as an expense. At period end, you move the unused portion back to an asset.

• At payment: debit the expense account, and credit Cash or Accounts payable.
• At period end: debit Prepaid expense, and credit the expense account for the portion not yet used.

Worked example: annual insurance premium

Suppose a company pays $12,000 on January 1 for a 12-month insurance policy and uses the asset method. At payment, it debits Prepaid insurance and credits Cash for $12,000. Then, at the end of every month, it records the same entry: debit Insurance expense and credit Prepaid insurance for $1,000 ($12,000 ÷ 12).

The same entries work for prepaid rent and other prepaid costs. Only the account names change, such as Prepaid rent and Rent expense.

For a multi-year prepayment, split the balance between current and non-current. A $36,000 three-year service contract paid upfront starts as $12,000 current and $24,000 non-current. At each year end, $12,000 moves from non-current to current until the remaining balance is fully current. This example is illustrative.

Prepaid expenses vs. accrued expenses

The difference is what comes first, the cash or the expense. A prepaid expense is paid before the benefit is received, so it starts as an asset. An accrued expense is incurred before it’s paid, so it starts as a liability.

A year of software paid upfront is a prepaid expense. Wages earned in the last week of the month but paid the following month are an accrued expense. Payments a business receives in advance from customers aren’t prepaid expenses at all. They’re unearned revenue, a liability.

Prepaid expenses at month-end

At month-end, the job is keeping the prepaid schedule and the general ledger in agreement. The prepaid balance on the balance sheet should tie to the remaining balances on the schedule. A roll-forward makes the check quick: the beginning balance, plus additions, minus amortization, plus or minus adjustments, equals the ending balance.

Frequently asked questions

Are prepaid expenses recorded as an asset?

Yes, prepaid expenses are recorded as an asset on the balance sheet, because they represent a future benefit the business has already paid for. The portion expected to be used within 12 months, or the operating cycle if longer, is a current asset. Any longer-term portion is a non-current asset.

Are prepaid expenses debit or credit?

Prepaid expenses are a debit when they’re recorded, because the asset account increases. As the benefit is used, the prepaid account is credited and an expense account is debited. Under the expense method, the period-end adjusting entry debits the prepaid account for the portion not yet used.

Can prepaid expenses be converted into cash?

Generally, prepaid expenses can’t be converted into cash, because they’re used up rather than collected. That’s why they aren’t treated as a liquid asset. Some prepayments can be refunded, depending on the vendor’s terms, and an expected refund is recorded as a receivable until the cash arrives.

How long can prepaid expenses be carried on the balance sheet?

Prepaid expenses can be carried on the balance sheet until the benefit is used, which depends on the terms of the arrangement. The portion used within 12 months, or the operating cycle if longer, is a current asset. A longer-term portion is non-current and moves to current as it comes due.

Are prepaid expenses tax-deductible?

Whether prepaid expenses are tax-deductible depends on the rules that apply. In the United States, prepaid expenses are generally capitalized, but the 12-month rule can allow a deduction in the year paid. Other requirements still apply, including the economic performance rules for accrual-method taxpayers. Confirm the treatment with a tax professional.

What is the 12-month rule for prepaid expenses?

The 12-month rule for prepaid expenses is a US tax rule that lets a business deduct a prepayment instead of capitalizing it. It applies when the benefit doesn’t extend beyond the earlier of 12 months after it begins or the end of the tax year after the payment (Treas. Reg. §1.263(a)-4(f)). For example, a one-year premium paid December 1 for a policy starting December 15 can qualify, but one starting February 1 can’t. It’s a tax rule only, and book accounting still amortizes the prepaid.

How do prepaid expenses impact financial statements?

Prepaid expenses impact the financial statements in three places. On the balance sheet, the unused balance is an asset. On the income statement, the cost is expensed over the periods it benefits. On the cash flow statement, the cash outflow is recorded when the payment is made, not when the expense is recognized. Under the indirect method, an increase in prepaid expenses reduces operating cash flow.

Can prepaid expenses be amortized?

Yes, prepaid expenses are amortized over the period they benefit. Straight-line amortization divides the total prepayment by the number of months in the benefit period, so a $12,000 annual policy is expensed at $1,000 a month. The worked example above shows the full schedule.

Can prepaid expenses be refunded?

Prepaid expenses can be refunded in some cases, depending on the vendor’s terms. If a refund is owed, the amount moves from the prepaid account to a receivable until the cash arrives. A non-refundable prepayment that won’t be used becomes an expense in the period it’s clear the benefit won’t be received.

How do I adjust prepaid expenses at the end of the accounting period?

To adjust prepaid expenses at the end of the accounting period, calculate the portion used during the period. Then record an adjusting entry that debits the expense account and credits the prepaid account for that amount. Under the expense method, the entry instead moves the unused portion back to the prepaid account.

What happens if prepaid expenses expire?

When prepaid expenses expire, any remaining balance becomes an expense in that period, because the asset no longer represents a future benefit. If the benefit was used evenly over the term, the balance should already be at or near zero when it expires.

What is the impact of prepaid expenses on financial ratios?

The main impact of prepaid expenses on financial ratios is a higher current ratio, because they’re included in current assets. The quick ratio usually excludes them, since they can’t be turned into cash. In an illustrative example, a $15,000 prepaid balance raises current assets, and the current ratio, without adding any cash. Prepaid expenses also affect profitability ratios through the timing of expenses.

Are prepaid expenses subject to depreciation?

No, prepaid expenses aren’t subject to depreciation. They’re amortized as the benefit is used. Depreciation applies to tangible fixed assets, such as equipment and buildings, and is recorded with a depreciation journal entry.

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This page is general information, not tax, accounting, or legal advice. Treatment depends on your accounting framework and jurisdiction. US GAAP is assumed unless stated, and tax statements apply to the United States only.