What is a Prepaid Expense?
A Prepaid Expense refers to payments made in advance for products or services expected to be received on a later date — most often related to utilities, insurance, and rent.
- What is the definition of a prepaid expense?
- Are prepaid expenses treated as an asset or liability on the balance sheet?
- Why might a company pay for an expense in advance?
- How do prepaid expenses compare to deferred revenue?
Prepaid Expense Definition
If a company decides to pay for a product or service in advance, the upfront payment is recorded as a “prepaid expense” in the current assets section of the balance sheet.
Under the matching principles of accrual accounting, revenue and expenses must be recognized in the same period.
Prepaid Expense Schedule — Accounting Treatment
Prepaid expenses represent future expenses paid in advance — so, until the associated benefits are realized, the expense remains a current asset.
The prepaid expense is listed within the current assets section of the balance sheet until full consumption (i.e. the realization of benefits by the customer).
Since prepaid expenses are categorized as “current” assets, the benefits associated with the products or services paid for upfront are expected to be used within the next twelve months.
Once the benefits of the assets are gradually realized, the prepaid expense is reduced as the asset is expensed on the income statement.
Comparable to the mechanics of a depreciation and amortization schedule, the prepaid expense asset incrementally declines until the balance eventually reaches zero.
Simultaneously, as prepaid expenses decrease, the expenses appear on the income statement in the period corresponding with the coinciding benefit.
Prepaid Expenses vs Accrued Expenses
One notable difference between prepaid expenses and accrued expenses is the treatment on the balance sheet:
- Prepaid Expenses → Current Asset
- Accrued Expenses → Current Liabilities
Furthermore, the prepaid expense line item stems from a company paying in advance for products/services anticipated to be used at a later date.
In contrast, accrued expenses are costs incurred by a company but not yet paid for, typically due to the absence of an invoice (i.e. waiting on the bill).
Example of Prepaid Expense
One frequent example of prepaid expenses is insurance coverage, which is often paid upfront to cover multiple future periods.
Here, we’ll assume that a company has paid for insurance coverage in advance due to the incentives offered by the provider.
If the company makes a one-time payment of $24,000 for an insurance policy with twelve-month coverage, it would record a prepaid expense of $24,000 on the initial date.
In the coming twelve months, the company recognizes an expense of $2,000/month — which causes the prepaid expense asset on the balance sheet to decrease by $2,000 per month.
- Initial Prepaid Expense = $24,000
- Monthly Expense on Income Statement = $2,000
By the end of the twelve-month coverage period, the entire insurance benefits are delivered, the total expenditure was expensed, and the corresponding prepaid expense asset on the balance sheet declines to zero.
Forecasting Prepaid Expenses in Financial Models
Prepaid expenses are typically modeled to be tied to operating expenses (OpEx).
However, if the connection between prepaid expenses and OpEx is unclear, the projection of prepaid expenses can be linked to revenue growth as a simplification.
Prepaid expenses are usually minuscule in relative size and rarely have a significant impact on a company’s valuation — hence, prepaid expenses are often aggregated with the “Other Current Assets” line.