Prepaid expenses are amounts a business has paid in advance for goods or services it will receive or use in a later period. Common examples are insurance premiums, rent paid ahead, annual software licences and subscriptions, maintenance contracts and advance payments to suppliers. Under IFRS reporting they are often called prepayments.
Under accrual accounting, a prepaid expense is not an expense when it is paid. It is recorded as an asset, because the business has a right to a future benefit, and is moved to the income statement as that benefit is used up. It is the mirror image of deferred revenue: the supplier that received the cash records a liability, the payer records a prepaid asset. Prepaid expenses should not be confused with prepaid cards or prepaid access, which are payment products.
Prepaid expenses in plain terms
If you buy a 12-month bus pass on 1 January, you haven't used up all that money on day one. You have a pass worth a year of rides. Each month, one twelfth of its value gets used. By December the pass is nearly worthless, and by the end of the year all of the cost has been "spent" on rides.
Accountants treat a business's advance payments the same way: the money paid upfront sits on the books as something the business owns, and a slice is moved to costs each month as it is used.
How prepaid expenses are recorded
For a benefit used evenly over time, the monthly charge is:
Example: on 1 January a company pays $12,000 for a year of insurance. The monthly expense is . On payment:
| Account | Debit | Credit |
|---|---|---|
| Prepaid insurance | $12,000 | |
| Cash | $12,000 |
At the end of each month, an adjusting journal entry debits insurance expense $1,000 and credits prepaid insurance $1,000. After three months, the balance sheet shows $9,000 of prepaid insurance and the income statement shows $3,000 of insurance expense. Benefits that are not used evenly, such as a block of consulting hours, are released in line with actual use.
Prepaid expenses sit alongside several other period-end balances that are easily mixed up:
- Accrued expenses. The opposite timing: the benefit has been used but not yet paid for, so a liability is recorded instead of an asset.
- Supplier deposits. Refundable deposits, such as a lease security deposit, are receivables rather than prepayments, because the money is expected back rather than used up.
- Capital expenditure. Payments for long-lived assets such as equipment are capitalised and depreciated, not treated as prepaid expenses, even though both spread a cost over time.
Typical prepaid items include insurance, rent paid ahead of the month, annual software fees and advance payments for marketing or events.
Presentation and control
Prepaid expenses that will be used within 12 months are current assets and form part of working capital; amounts covering later periods are shown as non-current. Many businesses set a materiality threshold below which small prepayments are simply expensed when paid. Prepayments are tracked in a schedule, sometimes a subledger, listing each item, its start and end dates and the remaining balance. During the financial close, the schedule is reconciled to the general ledger through account reconciliation, so that an expired policy is not left sitting as an asset.
Prepaid balances also affect cash analysis. A large prepayment reduces cash without reducing profit, so it appears as a working capital outflow in the statement of cash flows, and it is relevant to cash forecasting.
Tax treatment
Tax rules on prepayments differ from accounting rules and by country. In the US, a Treasury regulation under section 263(a) of the Internal Revenue Code includes a "12-month rule": a business generally need not capitalise a prepayment for a benefit that does not extend beyond the earlier of 12 months after the benefit begins or the end of the following tax year, so a business using the cash method can often deduct it when paid. Businesses using the accrual method must also meet separate economic-performance rules. Other countries have their own tests, and businesses using cash accounting for tax often deduct small prepayments when paid.