What Are Prepaid Expenses and How to Record Them Properly

Prepaid expenses refer to expenses paid before the expense is incurred. Any time you pay a bill in advance, it’s considered a prepaid expense and should be recorded as such.

Paying expenses is part of doing business. But some expenses are handled differently than others. For example, if you pay your rent on January 31 for February, that is not a prepaid expense. But if you pay your rent for the entire upcoming year, that is a prepaid expense and needs to be recorded as one.

Learn more about prepaid expenses, how they impact your financial statements, and why they need to be recorded differently from regular expenses.

Overview: What is a prepaid expense?

A prepaid expense is any expense you pay that has not yet been incurred. Also known as deferred expenses, recording these expenses is part of the accrual accounting process. It requires you to record expenses when they're incurred, accounting for them at that time. If you’re using cash basis accounting, you don’t need to worry about prepaid expenses. In cash accounting, you only record an expense when money changes hands.

A prepaid expense will show up on your balance sheet as an asset, and as the asset is used, it will appear on your income statement as an expense.

For example, you move into a new building at the end of December, with your first month’s rent due Jan. 1. Because your new landlord allowed you to move in early, he's now requesting you pay rent for the entire year, in advance.

Your monthly rental payments are $2,000, so you pay the entire $24,000 at the end of December, debiting a prepaid rent expense account and crediting your bank account for $24,000, with the prepaid rent account recorded as an asset account.

When January comes around, you would then debit $2,000 as rent expense for January and credit your prepaid rent expense account for $2,000, leaving you with a balance of $22,000. The $2,000 you expensed for January’s rent appears on your income statement as rent expense, while your prepaid rent asset account is reduced by $2,000 on your balance sheet. At the end of the year, you will have expensed the entire $24,000, and your prepaid rent account will have a $0 balance.

Sometimes, your accounting software can handle the amortization expense creation process, so your monthly journal entries will be completed automatically. If you’re using manual ledgers for your accounting, you can create a spreadsheet outlining your monthly expenses that will need to be recorded in your general ledger as an adjusting entry.

How to record a prepaid expense

You'll take several steps to record your prepaid expenses properly. This starts with determining if the amount should be expensed over multiple accounting periods, how much should be expensed each period, and for how long. For example, if you prepay accounting fees for $1,650, to cover the next six months, you would need to expense $275 each month for six months.

1. Pay the expense

The first step in recording a prepaid expense is the actual purchase of the expense. For example, if you pay your insurance for the upcoming year, you would first pay the expense, making sure to record it properly.

This journal entry is completed to establish your Prepaid Insurance asset account that represents the prepaid amount. The entry also reduces your Cash Account by the amount paid. Remember, to track prepaid expenses properly, they need to be recorded in your general ledger as a prepaid expense asset, with a portion of the prepaid asset accounted for each month as an expense.

2. Record the expense in your general ledger

Your next step would be to record the insurance expense for the next 12 months. You may be able to set up a recurring journal entry in your accounting software that will complete this automatically. If not, you’ll need to create an amortization schedule to help you determine how much you need to pay each month and for how many months. This is particularly important if the time frame is less than 12 months.

The journal entry above shows how the first expense for January is recorded.

3. Enter the monthly expense for each accounting period

Because you split the insurance expense evenly for the year, you will need to record the expense each month, meaning the above journal entry will need to be recorded each month for the next twelve months.

If you’re creating a spreadsheet to track your monthly expense, it would look like this.

The spreadsheet would continue through December, displaying the amount that will need to be expensed each month. This can be helpful for creating your monthly adjusting entries.

These entries will also affect your financial statements, with your asset account (Prepaid Insurance) steadily reduced while your Insurance Expense amount will increase.

4. Continue the process until the prepaid expense account is $0

In December, you will record the journal entry one last time. This final entry will close out your Prepaid Insurance balance to $0, while your Insurance Expense for the year will be $12,000.

Examples of prepaid expenses

Almost any expense paid in advance can be considered a prepaid expense. Here are common prepaid expenses that small businesses may incur.

• Insurance (health, life, and property)
• Taxes
• Rent
• Legal fees
• Retainers
• Bulk supplies
• Anything paid for in advance

For example, because of recent legal issues, Jill puts her attorney on retainer. The retainer fee is $3,000 annually. Though she pays the retainer in full, Jill still needs to determine how much she will need to expense each month as the retainer is used.

$3,000 ÷ 12 = $250

First, Jill will need to record the initial payment to her attorney for $3,000.

After her payment is recorded, Jill will then need to record the legal expense each month until the retainer is used and the Prepaid Legal Fees account has a $0 balance.

Prepaid expenses can be easily managed

If you’re not an experienced accountant, managing prepaid expenses may seem complicated, but it’s simply a matter of recording the cost as an asset and then taking an expense each month to use up part of that asset.

The easiest way to manage prepaid expenses is by using accounting software, which will automatically post a journal entry each month to reduce the balance in your prepaid accounts. But even if you simply use a spreadsheet to calculate your monthly expenses, managing prepaid expenses is one of the easier things you’ll need to manage.