Definitions: Prepaid Expense

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What is a prepaid expense? The technical definition according to U.S. Generally Accepted Accounting Principles is that a prepaid expense is an “amount paid in advance to secure the use of assets or the receipt of services at a future date.”

Prepaid expenses are assets that usually are shown on the balance sheet as current assets since they are typically expected to be used up within one operating cycle.

A common example of a prepaid expense is prepaid insurance. Business insurance policies usually cover a period of six months to a year and are paid by the business at the beginning of the policy coverage period. In order to show the true nature of the transaction, the actual expense for the policy needs to be evenly recognized over the time that it is active instead of up front in a lump amount. When the payment is made to the insurance company the payment is recorded to a prepaid expense account and amortized over the life of the policy.

Example: Company ABC purchases a general liability insurance policy to cover the business for a period of 12 months. The cost of the policy is $1,200 and paid up front to the insurance company. The entry to record the original payment would be to decrease cash by $1,200 for the check written and to increase prepaid expenses by $1,200:

Prepaid Insurance$1,200
Cash$1,200

Each month after the purchase of the policy Company ABC would recognize that month’s expense by reducing the prepaid insurance account by $100 ($1,200 / 12 months) and increase the insurance expense account by the same amount until the prepaid insurance account reaches $0 as shown:

Insurance Expense$100
Prepaid Insurance$100

Please contact us if you have any questions about this or any other small business topics.

This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.

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