Definition: A prepaid expense is the prepayment of services before they are received. In other words, it’s a resource that is paid for in advance of actually receiving the resource.
What Does Prepaid Expenses Mean?
Since the matching principles requires that all expenses be matched with the revenues they help generate, prepaid expenses are not recorded as expenses when they are purchased. Instead, these expenses are recorded as assets on the balance sheet because they are future resources that will be received in another accounting period . When the assets are used, they are recorded as expenses.
The most common examples of prepaid costs are reoccurring monthly bills like rent, utilities, and insurance. Let’s take a look at an insurance example.
Assume that Bill’s Retail Store pays its liability insurance premiums every six months. At the end of the six-month period, the policy is renewed and Bill pays $600 for another six-month period. When Bill makes his premium payment, he is actually paying for six months worth of insurance. In other words, he is paying for these benefits in advance of when he is actually going to use them.
Thus, Bill would record a $600 prepaid expense when he makes his six-month premium payment by debiting the prepaid insurance account and crediting the cash account for $600. At the end of each month, Bill would expense the prepaid insurance by debiting insurance expense and crediting prepaid insurance account for $100. As you can see, Bill records the expenses as he actually uses the insurance. By the end of his six-month policy, all of the prepaid account will be expensed and Bill will be able to renew his policy again.
As you can see, the prepaid concept follows the matching principle by waiting to recognize the expenses until the period when they benefit the company. This concept is also consistent with the accrual basis of accounting where income and expenses are recorded in the period in which they are incurred—not necessarily the period in which they are paid.