Prepaid expenses: Definition, examples, and accounting guide

Paying in advance for expenses such as rent, insurance, and subscriptions can help with budgeting and planning. You know you have the cash today, and it helps you lock in a lower price. But prepaid expenses can be a challenge if you don’t know how to record them properly.

Prepaid expenses are costs your business pays up front for goods or services it will receive in future accounting periods. You record them as current assets on the balance sheet until you realize the benefit.

In this article, we clarify what prepaid expenses are and why they matter. We'll also provide common examples, explain how to record them, and offer tips on how automation can help.

What are prepaid expenses?

Prepaid expenses are payments made in advance for goods or services to be received in the future. You record them as prepaid assets on your company’s balance sheet until you realize the benefit of the product or service. When that happens, you shift the amount to your income statement as an expense.

There are several reasons why your business might prepay for expenses, including the opportunity to secure discounts, take advantage of tax deductions, and improve cash flow. But what does prepaid mean? And what’s the difference between a prepaid expense and a regular expense? The answer relates to how you record the expense for accounting purposes.

In prepaid accounting, you record a prepaid expense as a current asset because of its future value to your business. It gradually becomes an expense as the benefit comes to life through amortization. You generally record regular expenses as an expense in real time, and you typically classify them as current assets because your business expects to use the product or service within a year.

Examples of prepaid expenses

Here are some common prepaid expenses your business may encounter, along with example scenarios for each:

• Prepaid rent: A business pays prepaid rent for the next six months. The prepaid amount is gradually moved from the prepaid asset to the income statement.
• Prepaid insurance: A company pays for an insurance policy for the year. The payment is initially recorded as a prepaid expense account and amortized monthly.
• Prepaid subscriptions: A company pays for an annual subscription to a service. The prepaid expense is recorded and expensed monthly.
• Prepaid advertising: A business pays up front for advertising services that will be provided over several months

Let’s go into a bit more detail on each example.

Prepaid rent

Prepaid expenses are most effective when you have a large sum of money available. Prepaid rent makes sense if you’re able to pay from that sum to gain a more favorable lease agreement. You may pay six months or a year in advance to secure the space and pay less in the long run.

You first record prepaid rent on the balance sheet as a prepaid asset. However, over the course of the lease, you gradually recognize it as an expense on the income statement, reducing the initial asset balance. You initially list it as an asset because of its future benefit to your business.

Prepaid insurance

While you can pay some insurance policies monthly or semi-annually, it’s more likely that you would pay the premium as a prepaid expense up front. You’re paying for the coverage in advance so you have it when you need it in the future.

On your balance sheet, you record prepaid insurance within your prepaid expenses. You then amortize that number as a regular expense on your income statement. Like prepaid rent, prepaid insurance is considered an asset because of its future benefit for your company.

On a prepaid insurance journal entry, you first list a debit in your prepaid insurance account (the asset) and a credit for the same amount as cash. Each period of amortization (generally monthly), you would create an adjustment entry to transfer a portion of the prepaid asset to the insurance expense category. This reduces the cash amount and recognizes the monthly expense.

Prepaid subscriptions

Prepaid subscriptions for magazines, software, or services are very common. Imagine your company uses a marketing tool that bills monthly. You might prepay an annual cost to lock in a lower price.

You first record these prepaid subscriptions as assets on the balance sheet, but you can make adjusting entries monthly to gradually move that upfront amount to the expense category.

Prepaid advertising

Likewise, your business may pay for a media buy in full before it hits the market. This is known as prepaid advertising. On your balance sheet, you initially recognize prepaid advertising as an asset, and then you adjust it to the expense category during each period you receive the benefit.

Let’s say you’ve spent $24,000 on a yearly advertising campaign. You could amortize this monthly, recognizing a $2,000 expense each month.

Or, if there's a larger push at the beginning of the year and smaller campaigns later, you might recognize an expense of $12,000 in the first quarter, and $4,000 in each subsequent quarter. Your accounting practice should reflect the period in which you received the benefit for the initial asset.

Accounting for prepaid expenses

Recording prepaid expenses isn't as challenging as it might seem. It usually follows a set pattern that helps tell the full story of your business’s finances. However, it's important to recognize that your business's accounting method determines when and how you record prepaid expenses.

Recording prepaid expneses in cash vs. accrual accounting

Accrual and cash basis accounting are two accounting methods for recording transactions. Their primary difference lies in when you record payments.

If your business uses cash basis accounting, you record expenses when you pay them. So, if you were to prepay six months of rent, you’d record it as an expense when you made the upfront payment.

Accrual accounting records expenses when you receive the benefit, even if it’s not at the time of payment. So, if you prepay, you would record the initial payment as an asset and adjust the expense monthly as you use it. This process is a bit more complicated, so we'll cover it in greater depth below.

How to record prepaid expenses step by step

When you make a prepayment, it debits the prepaid expense account and credits the cash account for the full amount on your balance sheet. As you consume the prepaid amount over time, you make adjusting entries on your income statement to allocate a portion of the prepaid asset to the prepaid expense account.

Accuracy is crucial in this process, as it directly impacts financial reporting and compliance for tax purposes. Here's a breakdown of the steps for recording prepaid expenses on a balance sheet:

• Initial payment: First, make the initial payment for the product or service
• Recording an asset: Next, record the payment as an asset, acknowledging future value
• Periodic expensing: Finally, turn the assets into expenses periodically (monthly, quarterly, etc.) through adjusting entries

Here's a sample journal entry for a prepaid subscription to demonstrate how this works:

Common journal entry examples

Here are two typical journal entry examples for prepaid rent and prepaid insurance:

Both journal entries reflect the advance payment. Over time, you expense the prepaid amount on the income statement each month for the rent example and each quarter for the insurance example.

Why prepaid expenses matter

Accurately managing prepaid expenses ensures compliance with IRS regulations and Generally Accepted Accounting Principles (GAAP) and helps you maintain accurate financial statements. This is critical for managing cash flow and working capital.

Errors in recording or misclassifying assets and expenses come with serious risks. First, you can misrepresent your company’s financial health. This creates issues for budgeting and tax filing, and can lead to poor business decisions. At worst, there could be tax penalties or audits.

Tracking prepaid expenses allows you to allocate expenditures correctly across accounting periods and make sure each income statement reflects the true expense associated with each period.

This also helps you make informed budgeting decisions by understanding the timing of prepayments and their impact on financial statements, which ultimately improves your financial visibility and planning.

Tax implications of prepaid expenses

It’s important to understand the tax implications of prepaid expenses to comply with IRS regulations and maximize your deductions. The IRS provides specific guidelines on how prepaid expenses should be treated for tax purposes.

These are a few areas to be aware of:

• Prepaid expenses and tax deductions: You generally can’t deduct prepaid expenses in the year you pay them. Instead, you'd amortize them over the period in which you receive the benefits. This means you must deduct a prepaid expense that covers a future period, such as prepaid insurance or prepaid rent, in the same period you actually receive the service or benefit.
• Section 162 and prepaid expenses: Section 162 of the Internal Revenue Code allows you to deduct ordinary and necessary expenses. However, Section 461 applies to prepaid expenses, so you recognize them in the period you incur them, not when you pay them. For tax purposes, if the prepaid expense is for a period longer than 12 months, you must spread the expense over the life of the service or good.
• Special rules for certain prepaid expenses: Some prepaid expenses qualify for special treatment under the IRS de minimis rule. If the total prepaid amount is $5,000 or less, under specific conditions, you may deduct it in the year you pay it rather than amortizing it over time.
• GAAP vs. tax treatment: GAAP is focused on presenting the clearest possible picture of your company’s finances for investors and lenders. Tax accounting, for its part, is about following regulations and optimizing deductions.

Practical example: Prepaid rent and taxes

Let’s say you pay $24,000 for prepaid rent covering 12 months of occupancy. For tax purposes, you can’t deduct the entire $24,000 in the year you pay the rent. Instead, you must amortize the prepaid rent on a monthly basis, deducting $2,000 each month on your tax return.

However, if the rental agreement is more than 12 months long, the IRS might not allow immediate deduction of the full amount. Instead, you must spread the rent expense across the agreement term.

If you’re ever in doubt, you should also talk with a tax professional to make sure you’re following the correct procedures and taking advantage of any available tax benefits, such as the de minimis safe harbor for small prepaid amounts or any specific exemptions related to certain types of prepaid expenses.

Managing prepaid expenses with software

Managing prepaid expenses can be a complex task, especially when dealing with multiple payments across various periods. Accounting software plays a critical role in simplifying this process by automating key functions, reducing human error, and ensuring you recognize prepaid expenses correctly over time.

Automating amortization of prepaid expenses

One of the most time-consuming aspects of managing prepaid expenses is tracking and amortizing the payments over time. Accounting automation software like Ramp can streamline this process.

When you input a prepaid expense into the software, the system can automatically calculate the amortization schedule based on the terms you set: monthly, quarterly, and so on. This eliminates the need for manual journal entries and promotes consistency.

Tracking prepaid expenses in real time

Using software to track prepaid expenses in real time provides several benefits:

• Clear visibility: You can view all prepaid expenses in one place, categorized by asset account and status. This makes it easy to monitor upcoming adjustments and avoid missing any amortization entries.
• Alerts and reminders: Many accounting platforms allow you to set up automatic alerts or reminders for recognizing prepaid expenses. This ensures nothing slips through the cracks and helps you stay on top of your financial reporting.

Ramp offers a dashboard that displays prepaid expenses and their remaining amortization balance, sending reminders when the next adjustment is due.

Key features to look for in expense management software

You should base your criteria for choosing an expense management platform on your specific business needs, but here are some key features to look out for:

• Custom schedules: Software allows you to set custom schedules for various prepaid expenses so you recognize the expense correctly over the appropriate accounting periods. This is especially useful for companies with long-term prepaid expenses that span multiple fiscal years.
• Predefined templates: Many platforms allow you to create templates for recurring prepaid expenses, such as insurance, rent, and subscriptions, which you can automatically apply each month or year
• Integration with other financial systems: Look for seamless integration with other financial systems such as banking platforms, payroll systems, and enterprise resource planning (ERP) tools. This integration allows for better tracking of prepaid expenses and ensures that your accounting records stay updated in real time.
• Comprehensive reporting: Tools allow you to generate real-time financial reports that show the status of prepaid expenses, confirming your balance sheet is accurate
• Forecasting tools: Some platforms also provide forecasting capabilities that help predict future cash flow based on the current prepaid expenses
• Audit trails: Most accounting software keeps an audit trail of all adjustments and amortizations, making it easier to track changes and ensure that all entries comply with GAAP and other regulatory standards.

In the end, the case for automation is the time saved. Everything connects instantaneously, there's less risk of errors from manual entry, and, ultimately, you’ll be able to focus on what really matters in your business.

Prepaid expenses vs. accrued expenses

People often confuse prepaid expenses with accrued expenses, but they have different treatments. You record an accrued expense when you incur it, but you pay the expense later. In contrast, you record prepaid expenses when you make the advance payment, and you recognize the benefit over time.

These are the key differences between prepaid and accrued expenses:

Employee wages are a classic example of an accrued expense. Wages are earned over a pay period, but they aren’t actually an expense until they're disbursed on payday. In contrast, you pay a prepaid expense in advance, such as insurance coverage you’ve purchased and plan to use in the year ahead.

Streamline your prepaid expense management with Ramp

Managing prepaid expenses efficiently helps you maintain accurate financial records and remain compliant with accounting standards. With the right tools, you can automate tedious tasks such as amortization and journal entries, ensuring accuracy and saving valuable time.

Ramp’s accounting automation software streamlines the management of prepaid expenses, enabling you to stay on top of financial reporting and compliance. With features that automate key financial tasks and streamline your processes, Ramp enables you to focus on what truly matters: growing your business.

Ready to learn more? Try an interactive demo and see how it works.