Prepaid expenses: What they are and how to use them

What exactly are prepaid expenses?

Chances are, you’re already using them.

If you’ve signed up for an annual software subscription, paid a few month’s worth of your business's building lease in advance, or bought office supplies in advance, you’ve prepaid some expenses.

But are you recording these purchases as prepaid expenses in your financial accounts? Did you even know that was a thing?

In this article, we’re going to explain prepaid expenses.

We’ll explain what prepaid expenses are, how they are recorded in financial statements, common examples of prepaid expenses, and why its important for small businesses owners to be on top of them.

What are prepaid expenses? 

A prepaid expense is any business expenditure that you pay for in advance of that expense being incurred.

For instance, if you pay six months of rent for office space in advance, this would be considered a prepaid expense, as you’ve paid for a bill that hasn’t yet actually been incurred.

In financial accounting, these prepaid expenses are then recorded as assets on the balance sheet. This offsets the ledger entry for the cash that left your account when you paid the amount but has not yet appeared as an expense incurred.

Is a prepaid expense a current asset? 

Yes, prepaid expenses are typically considered a current asset.

That’s because prepaid expenses are generally expected to be consumed within the next 12 months.

If you’ve paid prepaid expenses even further in advance — such as a three-year software contract — your accountant may record this as a non-current asset, though this is less common.

How are prepaid expenses recorded in financial statements? 

Prepaid expenses are initially recorded in financial statements as current assets.

Their value is expensed over time on the income statement, as the expenses are actually incurred, invoices are received for the goods or services, and the benefits of the purchase are realized.

The journal entries for the initial recording look like this:

1. Debit: Prepaid Expense Account (Asset)
2. Credit: Cash/Bank Account

The expenses paid in advance will then be listed under current assets on the balance sheet. As the prepaid expense is used up, it must be recognized in the income statement under the relevant expense category.

These are the journal entries used to represent the realization of the prepaid expenses: 

1. Debit: Expense Account
2. Credit: Prepaid Expense Account (Asset)

Common examples of prepaid expenses in accounting 

Any expense paid in advance can be considered and recorded as a prepaid expense.

These are some of the most common examples you’ll come across in financial statements:

• Insurance premiums. These are very commonly paid on an annual basis.
• Software subscriptions. Most software is purchased on a subscription basis. Businesses can take advantage of better pricing by paying quarterly or annually, which can be considered a prepaid expense.
• Rent and leases. Organizations often pay the rent on their factory or office space in advance and do the same for leasing equipment, machinery, and vehicles.
• Utilities and telecommunications. Some utility companies may require advance payment.
• Maintenance agreements. Ongoing maintenance and cleaning contracts may be paid in advance annually or quarterly, even though they are only realized monthly.
• Retainers. Marketing, advertising, and legal retainers can also be paid in advance to access discounted pricing, which can be reflected as prepaid expenses in financial statements.
• Taxes. Certain taxes, such as property taxes, may be paid in advance. Some tax bodies require provisional tax to be paid in advance, which could also be considered a prepaid expense.

Why do small business owners need to understand prepaid expenses? 

Many small business owners are already paying for certain expenses in advance, but they may not be properly accounting for them in their financial statements.

Here’s why it's important to get a better handle on prepaid expenses and how they are used.

Impact on cash flow

Prepaid expenses mean an immediate cash outflow, even though you’re not going to be realizing the benefits of the goods or services you’re paying for some months to come.

This can strain cash flow if not planned properly.

Equally important here is planning for future prepaid expenses. If you’ve paid for a large software bill on an annual basis right now, you’ll still need to put money aside to ensure you can meet that recurring expense 12 months from now.

Impact on financial statement accuracy

Recognizing prepaid expenses in your financial statements is critical.

Any expense that is considered prepaid must be recorded as a current asset on the balance sheet and then gradually expensed over the period to which they relate.

Doing so ensures that your financial statements reflect your company’s true financial situation, something current and potential investors will want to confirm is the case.

It also helps you align with the matching principle.

This is an accounting principle that states that expenses should be recorded in the same accounting period as the revenues they help to generate, as opposed to when the actual cash is paid out.

Misclassifying prepaid expenses as immediate costs can lead to understating your business's assets and overstating your outgoings, which can skew financial reports and negatively impact business decision-making.

Strategies for managing prepaid expenses

Now that you’ve got a good idea of what prepaid expenses actually are, let’s cover off a few best practices for managing them.

Use financial management software

Using financial operations software is a good practice in general, but doing so can help you automatically map prepaid expenses over to the income statement as they are actually realized, ensuring you align with the matching principle.

Create a prepaid expense schedule

Use your financial management software tool to create and maintain a detailed schedule of all prepaid expenses, including conversion timelines, so you have an easily accessible report to access when conducting audits.

Speaking of.

Conduct regular audits

Implement an auditing cadence — quarterly should work for most businesses — where you review:

1. All new prepaid expenses incurred for the period to ensure they have been recorded accurately.
2. All existing prepaid expenses recorded to ensure that they are being expensed correctly on the income statement.

Prepaid expenses vs. accrued expenses

Prepaid expenses and accrued expenses are two kinds of entries you’ll find on financial statements.

They both relate to how a company records its expenses but represent opposite scenarios.

Prepaid expenses are those you’ve paid in advance for several months or even up to a year. They are recorded as a current asset and gradually expensed onto the income statement as they are recognized across the financial period to which they relate.

Accrued expenses are the opposite. They are recognized and have been incurred during the current financial period but have not yet been paid

They are recorded on the balance sheet as current liabilities. That liability is then reduced when a payment has been made, and cash comes out of the bank account.  

Prepaid expenses vs. prepayments 

Prepaid expenses and prepayments sound similar, but they are not the same thing.

A prepayment just means you pay your invoice earlier than the due date. For example, if you have a payment to a supplier due next month, but you decide to pay it now, that’s a prepayment.

A prepaid expense is a good or service you’ve paid for but not yet used. 

That’s the key difference. Prepayments are for goods or services received and used but for which the invoice is not yet due.

Get on top of prepaid expenses 

Prepaid expenses are an important part of financial recordkeeping.

Any time you pay for business expenses in advance of receiving and using them, you’re incurring prepaid expenses, and this needs to be reflected correctly on your financial statements.

The most effective small business owners keep on top of business expenditures — including prepaid expenses — with a modern, intelligent expense management solution.

These software platforms, such as BILL, can help you manage spending with employee spend cards, deep reporting capabilities, and insightful forecasts.

Dive into BILL Spend & Expense today and take control of prepaid expenses.