How to Record and Manage Prepaid Expenses

When running a business, you may incur prepaid expenses, which are goods and services paid upfront before you start using them. There are several reasons why business owners prepay for expenses in advance, such as:

• Receiving a discount or deal.
• Locking in a current rate (if they expect rates to increase).
• Deducting prepaid expenses when filing taxes.

Types of prepaid expenses 

Here are common examples of prepaid expenses

• Advertising
• Insurance
• Interest
• Legal retainers
• Office equipment
• Rent or leases
• Salaries/wages
• Supplies
• Taxes

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Calculating prepaid amortization

When you prepay for an expense upfront, you want to accurately show how it is consumed over time for accounting purposes. To do this, a business needs to calculate the cost of prepaid expenses each month, which is known as prepaid amortization. Basically, it’s the decrease in an asset's value over time. Another way to look at it, is how much an item would cost if divided into monthly payments.

For example, if you prepaid $24,000 for leased office equipment for a full year, dividing it by 12 months will equal a monthly prepaid amortization amount of $2,000. That means the value of the leased office equipment will decrease by $2,000 monthly.

How to record prepaid expenses

You’ll need to record prepaid expenses correctly for accounting purposes.

Here’s how to record prepaid expenses using the accrual and cash methods of accounting when filing your taxes.

Accrual method of accounting 

The accrual method of accounting reports income in the fiscal period in which it is earned, regardless of when payments are received. Expenses are deducted in the fiscal period in which they are incurred, regardless of whether they have been paid. 

For example, let’s say you have a fiscal year ending on December 31, 2024. Your company purchased prepaid insurance for an entire year (July 1, 2024 to June 30, 2025). You can only deduct six months of prepaid insurance as an expense in 2024. You can deduct the other six months as an expense in 2025.

Cash method of accounting

The cash method of accounting is based on reporting income in the fiscal period you received it and deducting expenses in the fiscal period you paid them.

For instance, you paid $1,000 for prepaid advertising on January 1, 2024, for a two-year contract (January 1, 2024 to December 31, 2025). Since you paid the entire amount in advance, on your 2024 tax return, you would deduct $1,000 in prepaid advertising expenses.

How to record prepaid expenses on a balance sheet

Prepaid expenses are recorded as an accounting line item in a company’s balance sheet.
It documents the goods and services that have been paid for ahead of time but haven’t been used yet. Over time, it should also show how the expenses are being used up. 

Here are the steps for recording the debits and credits on a balance sheet.

Step 1: Under the Assets column (debits), you will debit the amount of your prepaid expense.

Under the Liabilities column (credits), you will credit the same amount of your expense based on where the payment was withdrawn.

Step 2: In the following months, as you incur your prepaid expense, you will need to record the asset that is used up and credit the prepaid expense.

Prepaid rent example

Step 1: In January, your company paid $3,000 in prepaid rent for the month of February.
You will debit the prepaid rental expense by $3,000. 
You will credit the chequing account by $3,000 where you are withdrawing the payment.

Step 2: The next month, when you have incurred this rent expense, you will record the following line items:
You will debit the rent by $3,000.
You will credit the prepaid expense by $3,000.
 

If you prepaid rent for 12 months, you can follow the same steps above. All you have to do is divide the prepaid rent by 12 months to get the monthly prepaid amortization. Then, continue to enter monthly journal entries to reflect the incurred rental expense.

Prepaid expenses as current assets 

Prepaid expenses are recorded as current assets in accounting terms. Current assets are short-term assets you plan to use, sell, or convert to cash within one year. If you don’t use them within 12 months, they are considered long-term assets.