What are Prepaid Expenses?
Prepaid expenses are payments made in advance for products or services to be used in the future. Prepaid expenses are recognized as an asset because they provide future economic benefits to a company.
While prepaid expenses are initially recorded as an asset, they eventually transition to an expense on the income statement when the product or service is incurred.
Prepaid Expense Journal Entry
Suppose Company A paid 6 months upfront for office rent worth $12,000. The journal entry in month 1 for this would be prepaid rent increasing by $12,000 as a debit, and cash decreasing by $12,000 as a credit.
After the 6 months, the company runs out of prepaid rent, and therefore incurs a rent expense of $12,000 and cancels out the prepaid rent of $12,000.
Effect of Prepaid Expenses on Financial Statements
The initial entry to record a prepaid expense only affects the balance sheet. Prepaid rent will increase, while cash will decrease. Therefore, there will be no changes in the totals for current assets or total assets.
The second entry, however, does affect both the income statement and the balance sheet. On the income statement, rent expense is recorded, which increases expenses, and in turn, decreases net income. On the balance sheet, current assets decrease as prepaid rent decreases.
Examples of Prepaid Expenses
Examples of prepaid expenses include:
- Paying for a subscription for a year upfront because they were offering a large discount.
- Signing a 12-month lease for office space that requires 6 months of upfront payment.
- Paying for a 24-month insurance policy for office space with cash upfront.
Is Prepaid Expense an Asset?
Yes, prepaid expense is a line item recorded as an asset on the balance sheet. This is because it represents a future economic benefit to the company. For example, if a company pays for 12 months of rent upfront, it expects to receive the benefits of that in the form of having an office space over the next 12 months.
More specifically, prepaid expense is recorded as a current asset. It can sometimes be bucketed with other current assets like in the example below for PepsiCo’s balance sheet. To learn more about PepsiCo's financial statements, you can click here.
Are Prepaid Expenses Debits or Credits
From a company’s point of view, an increase in prepaid expenses is a debit. The corresponding cash decrease is a credit. Later, when the prepaid expense is used, a company records an expense for the product or service which is a debit, and the prepaid expense gets canceled out through a credit.
Key Summary Recap
- Definition: Prepaid expenses are payments made in advance for a product or service to be used at a later date.
- Balance Sheet location: Prepaid expenses are listed as an asset in the balance sheet. More specifically, they are listed under current assets.
- Prepaid Expenses Debit or Credit?: An increase in prepaid expenses is a debit, while a decrease in prepaid expenses is a credit.
Additional Resources
Want to level up your accounting? Consider checking out our Financial Accounting Essentials where we teach students how to build a balance sheet, income statement, and cash flow statement from scratch based on a set of transactions. You'll also learn to find, read, and analyze the financial statements of real companies such as Microsoft and PepsiCo. Students who have taken this course have gone on to work at Barclays, Bloomberg, Goldman Sachs, EY, and many other prestigious companies. Get started now!
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Introduction
Building a cash flow statement from scratch using a company income statement and balance sheet is one of the most fundamental finance exercises commonly used to test interns and full-time professionals at elite level finance firms.
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