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Prepaid expenses arise when a company pays in advance for goods or services it will receive in the future. Common examples include rent, insurance premiums, and legal retainers. Properly recording these transactions is essential—overlooking or misclassifying prepaid expenses can distort cash flow visibility and increase the risk of audits and compliance issues.
Beyond financial reporting, accurate management of prepaid expenses also supports better budgeting and decision-making. By tracking these payments carefully, companies can gain a clearer picture of current obligations and operational performance.
Explore what prepaid expenses are and best practices for recording them correctly, so you can build a clear prepaid expense policy that keeps your books accurate and reduces compliance risks.
What are prepaid expenses?
A prepaid expense is essentially a payment you make today for something your business will use later. Under accrual basis accounting, businesses record these payments as assets on the balance sheet and only recognize them as expenses when the benefit is actually received. This ensures that financial statements reflect the true timing of costs and revenues, rather than just when cash leaves the company.
For example, if a landlord requires first and last month’s rent, a business may record the last month’s payment as a prepaid asset, recognizing the expense only in the month the rental period applies. Similarly, insurance premiums are often paid in advance annually. The business then amortizes the total payment over the coverage period, expensing an equal portion each month. This method provides a more accurate view of monthly expenses and avoids overstating costs in a single period.
How to record prepaid expenses
Accounting for prepaid expenses is a straightforward process, but it requires careful attention to detail to stay compliant with accounting standards. Follow these best practices to keep your books audit-ready and gain a true picture of your company’s financial position.
Record the prepaid expense
The first step is to record the initial payment. For example, suppose a company pays $120,000 upfront for a 12-month insurance policy. The total amount is recorded as a prepaid asset on the balance sheet. The journal entry would debit the prepaid expense account for $120,000 and credit cash for the same amount. This treatment reflects that the benefit has not yet been used, so it should not appear as an expense on the income statement immediately.
Set up a dedicated prepaid account
Create a separate asset account specifically for prepaid expenses. Some companies even create subaccounts, such as “prepaid insurance” or “prepaid rent,” to track individual advance payments. This level of detail makes it easier to monitor balances, schedule amortization, and reconcile accounts.
Schedule periodic amortization entries
Prepaid amortization is the process of gradually recognizing the expense as the benefit is used. For insurance, each month the company debits the insurance expense account for $10,000 and credits the prepaid asset account for $10,000. This adjustment moves the cost from the balance sheet to the income statement, reflecting actual usage. Continue this process monthly until the full prepaid amount is expensed over the 12-month period.
Reconcile prepaid accounts regularly
Regular reconciliation ensures the balances in prepaid accounts align with contracts, invoices, and amortization schedules. Inaccurate balances can distort financial statements and potentially trigger compliance issues. Performing these reconciliations monthly or quarterly is a practical way to prevent errors from accumulating.
Maintain documentation for audit and compliance
Proper documentation is essential for audits and to demonstrate compliance with accounting standards. Keep contracts, invoices, and amortization schedules organized and readily accessible. Regularly reviewing and updating this paperwork during reconciliations makes the auditing process easier.
Prepaid expenses examples
Beyond common cases like liability insurance and office leases, businesses encounter a wide variety of other prepaid expenses. Here are several examples and how businesses typically record them.
Employee health insurance premiums
Many companies pay employee health insurance premiums upfront, either quarterly or annually. They will record the total cost as a prepaid asset on the balance sheet and then amortize it over the duration of the policy, usually on a monthly basis. This ensures the expense reflects the period in which employees actually receive coverage.
Payroll service subscriptions
Companies using third-party payroll or accounting services often pay for subscriptions in advance, sometimes for a full year. They record the full payment as a prepaid expense initially, then expense it proportionally over the subscription period as the service is delivered.
Prepaid meal plans or commuter benefits
Some organizations provide employee perks such as meal plans or transit passes and pay for these benefits upfront. Prepaid amortization allows the company to recognize the cost gradually, aligning the expense with the period the benefit is available to employees.
Recruiting fees
When working with recruiting firms, a company might pay a retainer in advance or prepay part of a placement fee. They would typically amortize the retainer monthly over the engagement period, while they will expense one-time placement fees in full once the hiring process is complete.
Additional prepaid expenses can include software licenses, maintenance contracts, and professional memberships. Tracking these carefully as prepaid assets and scheduling proper amortization means financial statements will accurately reflect the timing of costs and helps prevent overstating expenses in any single period.
Simplify global expense management with Oyster
For companies that operate internationally, managing prepaid expenses can get complicated, often requiring currency conversions and multiple invoice types.
Oyster helps finance and accounting teams manage prepaid expenses across countries, ensuring accurate tracking and reconciliation. Our platform streamlines global expense management across payroll, benefits administration, and other operations, helping teams maintain documentation and stay compliant.
Explore Oyster today and see how it can enhance your global employment operations.
FAQs
What is the difference between prepaid expenses and accrued expenses?
Prepaid expenses are payments made in advance for goods and services a company will use in the future. A business will initially record them as assets and expense them gradually over time as the benefit is received. Accrued expenses, on the other hand, are liabilities your company has already used but not yet paid for. A common example is a utility bill—you use electricity or water during the month, recognize the expense during that period, and make the payment in the following period. This distinction ensures that you match expenses to the period in which the benefit occurs, maintaining accurate financial reporting.
What is prepaid amortization?
Prepaid amortization refers to the process of gradually expensing a prepaid asset over its useful period. It’s an adjusting entry made in your accounting books to reflect the consumption or usage of a service or benefit over time. For example, a company paying a $12,000 annual insurance premium would record a monthly amortization entry of $1,000 to allocate the cost evenly across the year. This approach keeps financial statements aligned with the actual period in which the benefit is received.
Can prepaid expenses be refunded?
Whether prepaid expenses are refundable depends on the terms of the underlying contract. Some agreements allow for partial refunds if the contract is cancelled, while others don’t. For instance, paying for a year-long software license in advance often comes with a discount, but you typically can’t receive a refund if you stop using the service early. In many cases, access to the service continues until the end of the paid term, regardless of usage. Understanding the cancellation and refund terms is important when recording and managing prepaid assets.
About Oyster
Oyster is a global employment platform designed to enable visionary HR leaders to find, engage, pay, manage, develop, and take care of a thriving distributed workforce. Oyster lets growing companies give valued international team members the experience they deserve, without the usual headaches and expense.
Oyster enables hiring anywhere in the world—with reliable, compliant payroll, and great local benefits and perks.
