What is Prepaid Expenses?

A prepaid expense is an asset: you have paid for something you have not yet used. As the benefit is received, the asset is reduced and an expense recorded.

Common examples

• Annual insurance premiums
• Software subscriptions billed yearly
• Rent paid in advance
• Deposits on trade show space
• Maintenance contracts

Example

A business pays $6,000 in March for a 12-month software license. It records $6,000 as prepaid software, then expenses $500 each month through the following February with an adjusting entry.

Why it matters

Without this treatment, March shows a $6,000 expense and the next eleven months none, which distorts monthly profit. For management reporting, spreading the cost gives a truer picture.

Tax treatment

For tax purposes, the IRS's rules on prepaid expenses differ from book treatment. Under the 12-month rule described in Publication 538, many businesses can deduct a prepayment in the year paid if the benefit does not extend beyond the earlier of 12 months after it begins or the end of the following tax year. Your preparer applies the rule; a schedule of prepaid items in your books makes it easy.

Keeping a schedule

List each prepaid item with the amount, service period and monthly expense. Reconcile the prepaid account to the schedule at month end, and watch for renewals that need a new entry.

Compare with deferred revenue, the seller's side of a prepayment, and see our month-end close checklist.

Related terms

• Deferred Revenue: Deferred revenue is money received for goods or services the business has not yet delivered, recorded as a liability.

Browse more definitions in the small business glossary.