Paying for things upfront, like rent or insurance, is common in business. Managing those payments correctly in accounting terms is crucial. Prepaid expenses might seem straightforward, but they can have a big impact on your financial reporting and cash flow.
Read: A Complete Guide to Financial Statement Analysis for Strategy Makers
In this guide, we’ll explain prepaid expenses in clear terms: what they are, how they work in accounting, and the best ways to manage them.
If you’ve ever wondered how to handle payments made in advance and make the most of them in your financial planning, this guide is for you.
What Prepaid Expenses Are and Why They Matter
Prepaid expenses are payments your business makes before receiving goods or services, like insurance, rent, or a subscription, that will provide value in the future. Instead of counting these payments as expenses right away, they’re recorded as current assets because the benefit hasn’t been used yet.
Some payments, like insurance, must always be prepaid. You pay to protect your business in case something goes wrong in the future. No insurance company will cover an event that’s already happened. Other common examples include software subscriptions billed annually or upfront payments for leased equipment, providing benefits spread over time.
These expenses are important for two reasons. First, they help match costs to the periods they benefit, which keeps your financial reports accurate and useful. Second, they make cash flow more predictable by clearly showing what’s already paid for versus what still needs to be accounted for.
Every business deals with some form of expenses paid in advance. By understanding them, you’re making sure your accounting reflects the true state of your business.
Related: To see how prepaid expenses fit into your financial picture, check out our guide to managing current assets effectively.
How Prepaid Expenses Work in Accounting
Understanding how to record and adjust prepaid expenses is key to keeping your financial reports accurate. They involve tracking value over time and making sure costs match the periods they benefit.
Recording Expenses Paid in Advance
When your business pays upfront for goods or services, the payment is logged as a current asset. This ensures it’s tracked until the benefit is used. Prepaid expenses are recorded in the accounting system with a simple journal entry:
For example, if you pay $6,000 for six months of warehouse storage, the full amount goes into the prepaid expenses account. This keeps the payment out of your expense account until you start using the storage. By recording the payment this way, you ensure that your books reflect the value of what you’ve paid for but haven’t yet used.
This approach not only keeps your financial reporting accurate but also helps you plan for future adjustments as the benefit is realized over time.
Adjusting Prepaid Expenses Over Time
As you use the goods or services you paid for upfront, you need to move their cost from the prepaid expenses account to an expense account. You adjust periodically, often monthly, using a simple journal entry like this:
Following the previous example, you would adjust $1,000 each month. This reflects the portion of the prepaid amount that has been “used up” during the month.
These periodic adjustments ensure that your financial reports match expenses to the periods they benefit.
Prepaid Expenses on the Balance Sheet
As mentioned earlier, your balance sheet lists prepaid expenses under current assets. Over time, as the value is used up, the prepaid expenses account decreases.
After adjusting $1,000 for one month of storage from a $6,000 prepaid amount, the balance sheet would show $5,000 remaining as prepaid expenses. Over time, the prepaid expenses account will be fully reduced to zero, and the entire amount will have been recorded as an expense on your income statement.
Related: Learn more about the primary limitations of the balance sheet.
The Tax Side of Prepaid Expenses
Prepaid expenses can also affect your taxes. In many cases, you can only deduct the portion of a prepaid expense that applies to the current year. Payments that cover more than one year, like insurance policies or service contracts, must be split, with future amounts staying on the balance sheet as an asset.
For example, if a logistics company prepays freight costs for the next fiscal year, it won’t be able to deduct those expenses until the logistics company uses the services. The same applies to a multi-year insurance policy: only the portion that applies to the current year is deductible.
Keep detailed records of prepaid expenses and make sure your books are accurate. A tax professional can help you follow the rules and avoid mistakes.
Related: Learn more about financial statement limitations.
Common Prepaid Expenses Mistakes and How to Avoid Them
Mistakes with prepaid expenses can lead to inaccuracies in financial reports and errors that could prove expensive in the long run. Here are the most common ones:
Forgetting to Adjust Prepaid Expenses
This mistake happens because adjusting prepaid expenses isn’t always top of mind. It’s easy to focus on new transactions and forget about payments already made. Without a clear process or reminders, these adjustments can slip through the cracks, leading to overstated assets and inaccurate profits.
How to avoid: Build a habit of reviewing and adjusting prepaid expenses regularly. Accounting and/or FP&A software can also help by automating the process.
Recording Prepaid Expenses Incorrectly
A common mistake is treating prepaid expenses as regular expenses or placing them into the wrong accounts. This often happens when people don’t understand what qualifies as a prepaid expense or when they make entries in a hurry. Naturally, this can lead to messy financial reports and confusion during reviews.
How to avoid: Make sure your team understands how prepaid expenses work and where to record them. Label accounts clearly in your system and double-check entries when reviewing your books.
Not Reviewing Prepaid Accounts Regularly
Some businesses forget to review their prepaid accounts regularly, which can lead to small errors piling up over time. Payments that are no longer valid may remain in the prepaid account, or adjustments may not match the actual use of the goods or services.
How to avoid: Schedule monthly reviews to reconcile prepaid accounts. Make sure balances match the remaining value of the prepaid service or benefit.
Avoiding mistakes like missed adjustments or wrong entries and reviewing accounts regularly can make a big difference. With the right software and simple processes, managing prepaid expenses gets much easier.
See how tracking expenses affects overall cash flow with our guide to the cash conversion cycle, and guide to net working capital.
Conclusion
Prepaid expenses might seem like a small part of your business’s finances, but managing them properly is key to keeping your financial reports accurate and your cash flow predictable. By recording payments correctly, adjusting them over time, and avoiding common mistakes, you can stay on top of your books without the headaches.
Whether it’s rent, insurance, or software subscriptions, understanding how prepaid expenses work helps you make better financial decisions. With the right tools and processes in place, managing these payments can be simple and stress-free.
