Definition of Prepaid Expense: Examples & Tips

When it comes to running a business and upkeeping financial statements, you’re aware that it’s not always black and white. By looking at the definition of prepaid expense alone, it’s easy to see how the records can easily get confused or a key line item may slip through the cracks.

To help maintain the accuracy of financial statements, despite any prepaid expenses on the balance sheet, let’s take a look at how automation solutions can help. Before we dive into solutions, we’ll cover the basics of dealing with prepaid expenses.

Coming Up

1. What are Prepaid Expenses?

2. How to Understand Prepaid Expenses?

3. What is the Accounting Treatment of Prepaid Expenses?

4. What is Prepaid Expense Amortization?

5. What is an Example of Prepaid Expenses?

6. Are Prepaid Expenses Debits or Credits?

7. How to Forecast Prepaid Expenses in Financial Models

8. How Does Automation Help with Prepaid Expenses?

9. Final Thoughts

What are Prepaid Expenses?

Prepaid expenses are expenses that will occur in the future but are paid for upfront. The most common prepaid expense examples are rent and insurance.

While the concept of a prepaid expense is pretty easy to understand, the accounting that comes along with it is a bit more multi-faceted. We’ll shortly touch on how prepaid expenses start as an asset and then transform into an expense in due time.

But before doing so, it’s useful to note that prepaid expenses typically result in the business receiving value from the goods or services over several accounting periods.

Sure, the sound of dealing with a single asset over several accounting periods may make you want to run, but with the help of accounting automation software, it’s easier than you think. (We will also come back to this soon).

How to Understand Prepaid Expenses?

Prepaid expenses exist because it’s often the case that businesses will pay for goods or services before they arrive or use them. For this reason, they can’t be recorded as an expense from the get go. Instead, they have to only become an expense when the value is derived.

It could also be the case that a prepaid expense will be for an asset that will be used over several years. In this case, value is continuously extracted from the asset, so the expense associated with each period will need to be aligned with the value it delivers. That’s where prepaid expense amortization comes in.

Before we get into those details, let’s first see how you can record prepaid expenses according to accepted accounting standards.

What is the Accounting Treatment of Prepaid Expenses?

As promised, here’s how to handle prepaid expenses on your financial statements.

First, the prepaid expense will be recorded as an asset on the balance sheet. It will remain within the current assets section until full consumption. Eventually, it will need to be recorded as an expense, when the benefits of the assets are realized.

Given that you record the prepaid expense under the “current” assets section of your balance sheet, you’ll need to plan to use up the benefits within the following 12 months.

Over time, the prepaid expense gets recorded on the income statement as an expense. As the value is extracted, the corresponding amount incrementally declines from the assets column into the expense column. At the end of the schedule, the balance should reach zero.

What is Prepaid Expense Amortization?

Prepaid expense amortization refers to how the consumption of the prepaid expense is recorded in each accounting period.

At the end of the period, when all the benefits of the prepaid expense have been used, then the balance is reduced to zero. By definition, the amortization schedule is the gradual reduction of the asset amount to zero (thereby becoming an expense) to reflect the period in which the company used up the accrual.

What is an Example of Prepaid Expenses?

As mentioned, common examples of prepaid expenses are rent and insurance. Let’s break down insurance to showcase how the prepaid expense gets treated.

Let’s say that your business has to pay $24,000 upfront for the year’s worth of insurance coverage. On your balance sheet, you’d record $24,000 in the “Current Assets” column. Each month for the following year, you’ll recognize the $2,000 expense. As you recognize the expense, you’ll reduce the asset figure by the same amount each month.

This way, at the end of the year, you’ll be at a zeroed out balance between your prepaid asset and expense.

Are Prepaid Expenses Debits or Credits?

So, now that we get how the asset becomes an expense, let’s review how the credit and debit system will work when it comes to your financial records.

The prepaid account reflecting the service or good (in our example, insurance) will be debited. At the same time, you’ll credit your cash account. This way, your balance sheet will remain….balanced.

At each account period’s close, you’ll post a journal entry for the incurred expense within the period (based on the amortization schedule that was established). The journal entry will credit the prepaid asset account and debit the corresponding expense account on the income statement.

How to Forecast Prepaid Expenses in Financial Models

When including prepaid expenses into your financial forecast models, they typically are tied in with operating expenses.

In the event that you can’t connect your prepaid expense with operating expenses, it’s also possible to link them to revenue growth for simplicity’s sake.  

When considering the grand scheme of your business’ accounts and expenses, prepaid expenses generally don’t have that big of an impact, so it’s possible to group them under
“Other current assets.”

How Does Automation Help with Prepaid Expenses?

When it comes to dealing with any type of financial statements and records, financial automation solutions are here to help.

Rather than having to manually enter data, collect data from disparate sources, and store information across spreadsheets, you can utilize tools like SolveXia to keep everything organized in a central repository.

This helps to increase efficiency, reduce compliance risk, eliminate errors, and remove key person dependencies (and, of course, bottlenecks).

As you keep tabs on prepaid expenses, you’ll need to ensure all records are accurate when it comes to the financial close. An automation solution like SolveXia can help to execute your balance sheet reconciliations for you, in a fraction of the time, while minimizing error.

By using a tool like SolveXia to manage account reconciliations, you can free up your team’s time to focus on high-value and strategic tasks rather than tedious and monotonous manual tasks.

Furthermore, regardless of what kind of expenses you do have, you can leverage analytics to empower decision-makers and review that money is being spent wisely within your business.

Final Thoughts

Knowing the definition of prepaid expense is just the first step in properly managing them when it comes to your financial statements.

Naturally, the accuracy of financial statements cannot be overlooked, so it is of great benefit to implement a financial automation solution like SolveXia to help manage your financial data and reports.

Want to see how a tool like SolveXia can work for your organization? Get started by requesting a demo.

‍