Definition
A prepaid expense is an amount paid in advance for goods or services the business will receive in future periods, such as annual insurance, rent or software subscriptions. It is first recorded as a current asset and then transferred to expense, usually monthly, as the period it covers passes, so each month carries its own share of the cost.
How it works
Prepayments are the mirror image of accrued expenses: cash leaves before the expense is incurred. Recording the whole payment as an expense would overstate costs in the month of payment and understate them for the rest of the period.
A simple schedule listing each prepayment, its start date, end date and monthly amount makes the adjusting entries routine and supports the balance at year end. Include the review in your month-end close checklist.
Example: annual insurance paid in advance
On 1 April a company pays 12,000 for insurance covering 12 months. It debits prepaid insurance 12,000 and credits bank. At the end of each month it moves 1,000 to insurance expense. On 31 December the prepaid balance is 3,000, covering January to March.
| Date | Account | Debit | Credit |
|---|---|---|---|
| 1 April | Prepaid insurance | 12,000 | |
| 1 April | Bank | 12,000 | |
| 30 April | Insurance expense | 1,000 | |
| 30 April | Prepaid insurance | 1,000 |