Prepaid ExpenseDefinition & Examples

Written By:
Lisa Borga

What are Prepaid Expenses?

Prepaid expenses are a form of asset that is listed on the balance sheet.

This type of asset results from a business making advance payments for either goods or services in one accounting period, which will be received in a later accounting period.

These prepaid expenses will be listed on the balance sheet as an asset and will gradually be expensed over time as its economic future benefits are realized.

The Most Common Types of Prepaid Expenses

The two single most common types of prepaid expenses are rent and insurance.

Accounting for Prepaid Rent

When a business pays to rent a space in advance of the period in which it is used, this is called prepaid rent.

In order to account for this, a business would make the following journal entries.

The initial entry would be:

As the rent is used, the following adjusting journal entry would be made:

These adjusting entries would be made until the entire prepaid account has been expensed.

Accounting for Prepaid Insurance

Insurance policies are often paid in advance for an entire period, and this is prepaid insurance.

Until the policy expires, this would be listed on the balance sheet as an asset.

In order to account for this, the following journal entries would be made.

The initial entry would be:

As time passes and the policy is gradually used, the following adjusting entry would be made.

Examples of Prepaid Expenses

Let’s look at a couple of examples of prepaid expenses.

Example #1

Johnny’s Mattress Emporium signed a one-year leasing agreement for its retail location.

The agreement requires Johnny to pay the full amount for the year upfront, which is $240,000.

In order to account for this, the following initial journal entry would be made:

At the end of every month, Johnny’s Mattress Emporium would make an adjusting entry to account for the amount of the leasing agreement it has used.

Because the leasing agreement is for one year, the adjusting entry can be found by dividing the $240,000 by 12 months which will leave us with a $20,000 adjusting entry every month.

The resulting journal entry would look like this:

This adjusting entry would be repeated every month throughout the course of the leasing agreement.

After the year passes, the lease agreement will hold no more economic benefits, and the balance of the entire prepaid rent account will have been expensed.

Example #2

After opening its retail location, Johnny’s Mattress Emporium also needs commercial renters insurance to protect its assets.

For its insurance policy, it pays $36,000 in cash or a one-year policy.

In order to account for the prepaid insurance policy, Johnny would make the following initial journal entry:

Following this, Johnny’s Mattress Emporium would record an adjusting entry to account for the amount of the policy that it has used.

This would be $3,000 found by taking the $36,000 of the policy and dividing it by the twelve months of the policy.

The corresponding journal entry would look like this:

At the end of one year, all of the economic benefits of the insurance policy will have been consumed, and no balance will remain in the prepaid insurance account.

Impact of Prepaid Expenses on Financial Statements

A business’s financial statements are not affected by the initial journal entry it makes for a prepaid expense.

An example of this would be prepaid insurance.

To record the initial journal entry, prepaid rent is debited, and cash is credited.

This transaction does not cause an increase or decrease on the business’s balance sheet since both of these accounts are asset accounts.

Prepaid expenses are asset accounts due to the fact that they will produce an economic benefit for the business in the future.

The later adjusting journal entry that needs to be made for a prepaid expense will affect the balance sheet and the income statement.

Consider the second example above of prepaid insurance.

When the adjusting entry is made on February 1, it results in a $3,000 expense which results in a $3,000 decrease in assets.

The $3,000 expense would appear on the business’s income statement; whereas, the decrease of $3,000 in assets would show up on the balance sheet.

Key Highlights

• Prepaid expenses are expenses paid in advance for goods or services that will be received in the future.
• A prepaid expense is listed on the balance sheet, and as its benefits are recognized, it will be expensed, and the related asset account will be decreased.
• Common examples of prepaid expenses include prepaid rent and insurance.