# Prepaid Expense: Definition and Example

> **Definition**
>
> A prepaid expense occurs when a company pays in advance for goods or services it will receive in the future. These payments are recorded as assets on a company's balance sheet until the benefit of the good or service is realized.

Companies regularly pay for services they'll use in the future. Typical instances include rent, insurance, leases, marketing, retainers for lawyers, and estimated tax payments. Since these provide benefits in the future, companies record prepaid expenses as assets on their balance sheet, but they don't have to record the payments for them until they occur.

Large and small businesses alike work with prepaid expenses daily. A startup might prepay six months of office rent to secure better terms, while a global corporation might prepay millions in insurance premiums. Understanding how these transactions work is crucial for anyone interested in business operations or investing.

### Key Takeaways

*   Prepaid expenses appear as assets on a company's balance sheet because they represent future value, like having store credit you'll use later.
*   Most prepaid expenses convert to regular expenses within 12 months, so they're usually listed as current assets alongside cash and inventory.
*   Smart businesses use prepaid expenses strategically—like prepaying insurance or rent—to lock in better rates and manage cash flow effectively.
*   Proper tracking of prepaid expenses is crucial for taxes and financial reporting since the costs must be recognized in the same period the benefits are used, not when the payment is made.

![Prepaid Expense](https://www.investopedia.com/thmb/8v8KXJiLSif6k3Qmda5w2Vgm_9c=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/prepaid-expense-4191042-recirc-blue-1d8d154bf0c94ba6858fe12907d2b694.jpg)

*— Madelyn Goodnight / Investopedia*

## What Are Prepaid Expenses?

For businesses, prepaid expenses can include everything from office rent to [insurance premiums](https://www.investopedia.com/terms/i/insurance-premium.asp). Understanding how they work is crucial for both business owners and investors.

When companies make advance payments, they often do so for practical reasons. Sometimes it's to secure a discount, like getting a better rate on a year's worth of insurance paid upfront. Other times, it's simply required—a landlord might want the first and last month's rent before handing over the keys.

Companies have to track their prepaid expenses carefully: too many prepaid expenses can strain a company's cash reserves, while too few might mean missing out on bulk-payment discounts. Finding the right balance is part of effective financial management.

## Recording Prepaid Expenses

Accounting for prepaid expenses might seem tricky, but it follows a logical pattern that helps tell an accurate story of a company's finances. When businesses make advance payments, they first record them as assets—this acknowledges they've purchased something of future value. These assets turn into expenses as the company uses the service or product over time.

For example, if a company pays $60,000 for a year of liability insurance upfront, that full amount initially goes on the books as an asset called "prepaid insurance." Then, each month, it'll move $5,000 from that prepaid account into the company's expense column, reflecting that month's portion of insurance coverage.

Accountants call these monthly moves "[adjusting entries](https://www.investopedia.com/terms/a/adjusting-journal-entry.asp)," but you can think of them as progress payments marking how much of the prepaid service has been used. These regular adjustments ensure financial statements accurately reflect how much of the prepaid expense remains as an asset and how much has been consumed.

Getting these records right matters for more than just bookkeeping. Investors and [auditors](https://www.investopedia.com/terms/a/auditor.asp) look at how companies handle their prepaid expenses to gauge financial health and compliance with accounting standards.  

> **Important**
>
> According to generally accepted accounting principles (GAAP), expenses should be recorded in the same accounting period as the benefit generated from the related asset.

## Example of a Prepaid Expense

Suppose a tech startup pays $24,000 up front for an annual office lease. Here's how that transaction flows through its books:

First, it'll record the full $24,000 as a prepaid asset. Each month, as it occupies the office space, it'll convert $2,000 of that prepaid asset into a rent expense. This monthly conversion reflects how the company is using up 1/12 of the prepaid lease.

The process continues like clockwork: At the three-month mark, the firm will have $18,000 left as a prepaid asset and will have recorded $6,000 in rent expenses. By the six-month point, those numbers will be $12,000 and $12,000, respectively. This continues until the prepaid amount reaches zero at the end of the year.

## The Bottom Line

Prepaid expenses require careful tracking to ensure accurate financial reporting. Whether you're running a small business or analyzing investment opportunities, knowing how prepaid expenses work helps you better understand a company's true financial position.