Advance payment recorded as an asset at first and expensed later as the related benefit is used.
A prepaid expense is a payment made before the related service period or benefit has been used. Because the future benefit has not been consumed yet, the amount is recorded as an asset first and recognized as expense later.
Prepaid expenses are one of the clearest examples of timing in accounting. If they are expensed too early, profit is understated. If they stay on the balance sheet too long, assets are overstated and expenses are delayed.
Common prepaid balances include insurance, rent, software subscriptions, and service contracts paid in advance. The initial payment usually debits a prepaid asset account and credits cash. As time passes or the benefit is consumed, the business records an adjusting entry that moves part of the balance into expense.
A company pays 12,000 for one year of insurance on January 1:
| Account | Debit | Credit |
|---|---|---|
| Prepaid Insurance | 12,000 | |
| Cash | 12,000 |
At the end of the first month, one month of benefit has been used:
| Account | Debit | Credit |
|---|---|---|
| Insurance Expense | 1,000 | |
| Prepaid Insurance | 1,000 |
A prepaid expense is the opposite timing pattern from an accrued expense. Prepaids start as assets and become expenses later. Accrued expenses start as expenses and liabilities before cash is paid.