What is a Prepaid Expense?

by Greg DePersio

1 min read

A prepaid expense is an expense that you pay before you receive a product or service. An insurance policy is an example of a prepaid expense. When you buy an insurance policy for your office building, you buy a protection against something bad that might happen to your office building in the future.When you prepay for a product or service, you can’t record the full amount as an expense for the current accounting period in your income statement because you’ll receive the benefit of what you buy over a period of time. Instead, you record the full amount as a debit in the prepaid asset account and a credit in the cash account in your company’s balance sheet. Then you divide the prepaid expense up and record the portion that is relevant for the current period in your income statement. In other words, you spread the prepaid expense across the lifetime of the good or service.Let’s pretend the fiscal year-end of your business is December 31. On December 1, you prepay a year’s worth of rent that amounts to $12,000 for a new office. In your company’s balance sheet, you credit the $12,000 in the cash account and debit the same amount in the prepaid rent asset account. Despite having paid your rent upfront, you can only record a month’s rent (December 1-December 30) or $1,000 as rent expense on your income statement for December. Likewise, when you file your tax return, you can only claim $1,000 as rent expense for the current fiscal year.Prepaid expenses are considered assets for accounting purposes until they’re incurred, and you credit the asset accounts until you expense the full amount over time.

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