Prepaid expenses: Definition, examples, and accounting

Prepaid expenses are payments you make now for goods or services you’ll use later, like paying $12,000 in January for a full year of business insurance. You’ve paid the cash up front, but the benefit shows up gradually month by month.

Tracking prepaid expenses correctly keeps your financial statements accurate and your cash flow predictable. When you account for these advance payments properly, you can see what you’ve already paid for, when those benefits expire, and how costs should be spread across the right accounting periods.

What are prepaid expenses?

Prepaid expenses are advance payments for goods or services your business will receive or consume over time. You pay the cash up front, but you don’t recognize the full cost immediately because the benefit shows up in future accounting periods.

Under accrual accounting, expenses should be recorded in the same period as the benefit they provide. If you pay $24,000 for two years of software licenses, expensing the full amount right away would overstate costs in the current period. Instead, you recognize $1,000 per month as the software is used, which gives a more accurate picture of ongoing operating costs.

Because prepaid expenses represent future economic value, you record them on the balance sheet as assets. A $6,000 annual lease payment made in January becomes a prepaid asset that gradually turns into rent expense each month. The same applies to insurance, subscriptions, and other services paid for in advance.

Key characteristics of prepaid expenses

Prepaid expenses share several features that distinguish them from regular operating expenses:

• Payment timing: You pay for the good or service before receiving the benefit
• Benefit period: The payment provides value across multiple future accounting periods
• Asset classification: Prepaid expenses appear on the balance sheet as assets until they’re used
• Typical time frame: Most prepaid expenses are used within 12 months, though some extend longer

These traits help separate prepaid expenses from other operating expenses and explain why they require different accounting treatment.

Common examples of prepaid expenses

You’ll encounter prepaid expenses across many parts of your business, from basic overhead to longer-term service agreements. These examples show how advance payments typically work in practice.

Insurance premiums

Many businesses pay insurance premiums annually or semiannually to secure lower rates. A $12,000 annual general liability policy paid in January becomes a prepaid expense that you recognize evenly over the year. Each month, you move $1,000 from the prepaid insurance asset to insurance expense.

This applies to property insurance, professional liability coverage, and workers’ compensation policies. You get immediate coverage, but the expense is recognized gradually as the protection is used.

Rent and lease payments

Commercial leases often require first and last month’s rent up front. If your monthly rent is $5,000 and you pay $10,000 at signing, the final month’s rent sits as a prepaid expense until the end of the lease term. Some landlords also offer discounts for quarterly or annual rent paid in advance.

You expense the current month’s rent immediately and recognize the prepaid portion over time on your income statement.

Software subscriptions and licenses

Annual software subscriptions are one of the most common prepaid expenses. If you pay $2,400 in January for a year of project management software, you record $200 in expense each month as your team uses the tool.

Multi-year licenses follow the same pattern but over longer periods. A 3-year license costing $36,000 is recognized at $1,000 per month, preventing a large one-time expense from distorting a single period.

Other common prepaid expenses

Beyond rent, insurance, and software, businesses often prepay for services and supplies such as:

• Professional service retainers for legal, accounting, or consulting work
• Advertising campaigns paid up front and delivered over multiple months
• Equipment maintenance contracts for machinery or technology
• Office supplies purchased in bulk and used gradually

Each example follows the same logic: you pay in advance, record an asset, and recognize the expense as the benefit is consumed.

How to record prepaid expenses: Journal entries

Recording prepaid expenses affects both your balance sheet and your income statement. When you make the initial payment, you record an asset. As you use the prepaid item over time, you gradually recognize the expense. This two-step process keeps expenses aligned with the periods they benefit.

Initial recording entry

When you pay for a prepaid expense, you record it as an asset instead of an immediate expense. This reflects the future value your business has purchased.

For example, if you pay $12,000 on January 1 for a one-year insurance policy, the journal entry looks like this:

Cash decreases, but your total assets stay the same because you’ve exchanged cash for future insurance coverage.

Monthly amortization entry

As time passes and you receive the benefit, you recognize a portion of the prepaid expense on the income statement. For a 12-month policy, that means expensing $1,000 each month.

The monthly adjustment entry is:

This entry reduces the prepaid asset and records the cost in the period the coverage applies.

Step-by-step example

Here’s how that $12,000 insurance payment flows through your accounts over the first three months:

This pattern continues until the prepaid balance reaches zero at the end of the coverage period, ensuring expenses are matched to the months that benefit from them.

Prepaid expenses on the balance sheet

Prepaid expenses appear in the current assets section of your balance sheet because they represent benefits your business will use in future periods. You’ll typically see them listed after cash and accounts receivable and before inventory, either as a single line item or broken out by category.

They may be labeled as “Prepaid expenses,” “Prepaid assets,” or shown individually as prepaid insurance or prepaid rent. However they’re presented, the goal is the same: to show costs you’ve already paid that haven’t yet been recognized as expenses.

Balance sheet classification

Most prepaid expenses qualify as current assets because they’re used within 12 months. A six-month insurance policy or an annual software subscription stays entirely in current assets until it’s fully expensed.

If a prepaid expense extends beyond one year, you split it between current and non-current assets. The portion that will be expensed in the next 12 months remains in current assets, while the remaining balance is classified as a long-term asset.

Here’s a simplified example of how prepaid expenses might appear on a balance sheet:

Impact on financial ratios

Prepaid expenses increase your working capital because they raise current assets without increasing current liabilities. If you pay $20,000 up front for insurance, your cash decreases, but your total current assets remain the same until the expense is recognized.

They also affect your current ratio, which compares current assets to current liabilities. Adding prepaid expenses can improve this ratio on paper, even though prepaid assets aren’t as flexible as cash or receivables.

Because prepaid expenses can’t be converted back into cash, analysts often exclude them when calculating stricter liquidity measures like the quick ratio. Understanding this distinction helps lenders and investors interpret your liquidity more accurately.

Prepaid expenses vs. accrued expenses

Prepaid expenses and accrued expenses represent opposite timing situations in accounting. With prepaid expenses, you pay first and recognize the expense later. With accrued expenses, you recognize the expense first and pay later.

Understanding the difference matters because each one affects your balance sheet, income statement, and cash flow in different ways.

Key differences

The main distinction comes down to timing. Prepaid expenses involve advance payments for future benefits, while accrued expenses reflect costs you’ve already incurred but haven’t yet paid.

They also differ in how they appear on the balance sheet. Prepaid expenses are recorded as assets because they represent future value. Accrued expenses are recorded as liabilities because they represent amounts you owe.

Side-by-side comparison

When each applies

Prepaid expenses typically arise when vendors require advance payment or when you choose to prepay to lock in discounts. Common examples include annual insurance policies, software subscriptions paid up front, and rent paid ahead of the lease period.

Accrued expenses occur when you receive goods or services before receiving an invoice. Employee wages earned but unpaid, utilities used before billing, and interest that accumulates between payments are all common accrued expenses.

Confusing these two concepts can lead to misclassified assets or liabilities and distorted financial statements. The easiest way to tell them apart is to ask whether cash left your account before or after you received the benefit.

Best practices for managing prepaid expenses

Managing prepaid expenses effectively helps you keep accurate records, avoid missed adjustments, and stay audit-ready. Clear documentation, consistent processes, and regular reviews make prepaid expenses easier to track over time.

Documentation and recordkeeping

Strong documentation makes it easier to track prepaid expenses and support them during audits or internal reviews. You should retain:

• Original invoices and payment receipts showing amounts, dates, and coverage periods
• Vendor contracts and agreements that outline service terms and renewal dates
• Amortization schedules that track monthly expense recognition and remaining balances
• Approval records showing who authorized the prepayment and why it made sense

Amortization schedules act as a reference point for month-end close. A simple spreadsheet that tracks monthly expense amounts, remaining prepaid balances, and end dates can prevent missed or duplicate entries.

Setting calendar reminders or using accounting software to flag upcoming adjustments helps ensure prepaid expenses are recognized on time each period.

Internal controls

Approval thresholds help prevent unnecessary prepayments. Requiring manager approval for prepaid expenses above a set dollar amount encourages teams to evaluate whether paying up front actually benefits the business.

Regular reconciliations catch issues early. Comparing prepaid expense balances in your general ledger to amortization schedules each month can surface missed adjustments or posting errors before they compound.

Maintaining a clear audit trail is also essential. Each journal entry should link back to supporting documents such as invoices, contracts, and approval records so transactions are easy to review and verify.

Common mistakes to avoid

One of the most common errors is forgetting to amortize prepaid expenses, which overstates assets and understates expenses. Automating recurring entries or setting monthly reminders helps prevent this.

Another frequent issue is misclassifying long-term prepaid expenses. If a prepaid expense covers more than 12 months, only the portion that will be used within the next year should remain in current assets, with the rest classified as long term.

Incomplete documentation can also cause problems during audits or tax reviews. Keeping invoices, contracts, and schedules organized and attached to journal entries reduces friction and protects the integrity of your financial records.

Managing prepaid expenses with software

Managing prepaid expenses becomes more complex as your business grows and the number of advance payments increases. Business accounting software can simplify this process by reducing manual work and helping ensure expenses are recognized in the correct periods.

Automating amortization of prepaid expenses

Tracking and amortizing prepaid expenses manually is time-consuming and error prone. Accounting automation software can handle this work by calculating amortization schedules based on the time period you set, whether monthly, quarterly, or annually.

Once a prepaid expense is recorded, the software automatically posts the recurring adjustments. This reduces the risk of missed entries and keeps expense recognition consistent from period to period.

Tracking prepaid expenses in real time

Using software to track prepaid expenses in real time gives you better visibility into what’s been paid and what remains. You can see all prepaid expenses in one place, organized by account and status, which makes it easier to manage upcoming adjustments.

Many platforms also offer alerts or reminders for expense recognition. These prompts help ensure prepaid expenses are amortized on schedule and don’t get overlooked during month-end close.

Key features to look for in expense management software

When evaluating expense management software, look for features that support accurate and efficient prepaid expense tracking:

• Custom schedules that align expense recognition with the correct accounting periods
• Templates for recurring prepaid expenses such as insurance, rent, and subscriptions
• Integration with banking, payroll, and ERP systems to keep records in sync
• Reporting that shows prepaid balances and remaining amortization
• Audit trails that document adjustments and support compliance

Automate prepaid expense tracking and amortization with Ramp's AI-powered accounting

Tracking prepaid expenses manually is time-consuming and error-prone. You need to identify which transactions qualify as prepaid, calculate amortization schedules, and ensure expenses hit the right periods—all while keeping your books audit-ready. Miss a step, and you risk misstated financials or compliance issues.

Ramp's AI-powered accounting software handles prepaid expense tracking and amortization automatically, so you can close books faster with full confidence. Here's how it works:

• AI identifies prepaid expenses: Ramp's AI reviews every transaction and flags items that span multiple periods, learning your patterns to catch prepaid expenses as they post
• Automated amortization schedules: Ramp calculates and applies amortization automatically based on the expense period, posting entries to the correct months without manual intervention
• Real-time accrual posting: When transactions need to be recognized over time, Ramp posts accruals automatically and reverses them in the appropriate period, so expenses always land where they belong
• Period-accurate coding: Ramp ensures every prepaid expense is coded to the right GL accounts and periods, maintaining compliance and audit readiness throughout the year
• Full visibility and control: Review all prepaid expenses and their amortization schedules in one place, with complete transaction history and supporting documentation attached

With Ramp handling prepaid expense tracking and amortization, you eliminate manual calculations, reduce period-end adjustments, and ensure every expense is recognized accurately across the right periods.

Try an interactive demo to see how Ramp automates prepaid expense management from start to finish.