Over 2 million + professionals use CFI to learn accounting, financial analysis, modeling and more. Unlock the essentials of corporate finance with our free resources and get an exclusive sneak peek at the first module of each course.
Start Free
What are Prepaid Expenses?
Prepaid expenses represent expenditures that have not yet been recorded by a company as an expense, but have been paid for in advance. In other words, prepaid expenses are expenditures paid in one accounting period, but will not be recognized until a later accounting period. Prepaid expenses are initially recorded as assets, because they have future economic benefits, and are expensed at the time when the benefits are realized (the matching principle).
Summary
Prepaid expenses are future expenses that are paid in advance and hence recognized initially as an asset.
As the benefits of the expenses are recognized, the related asset account is decreased and expensed.
The most common types of prepaid expenses are prepaid rent and prepaid insurance.
Common Reasons for Prepaid Expenses
The two most common uses of prepaid expenses are rent and insurance.
1. Prepaid rent is rent paid in advance of the rental period. The journal entries for prepaid rent are as follows:
Initial journal entry for prepaid rent:
Adjusting journal entry as the prepaid rent expires:
2. Prepaid insurance is insurance paid in advance and that has not yet expired on the date of the balance sheet.
Initial journal entry for prepaid insurance:
Adjusting journal entry as the prepaid insurance expires:
Prepaid Expenses Example
We will look at two examples of prepaid expenses:
Example #1
Company A signs a one-year lease on a warehouse for $10,000 a month. The landlord requires that Company A pays the annual amount ($120,000) upfront at the beginning of the year.
The initial journal entry for Company A would be as follows:
At the end of one month, Company A would’ve used up one month of its lease agreement. Therefore, prepaid rent must be adjusted:
Note: One month corresponds to $10,000 ($120,000 x 1/12) in rent.
The adjusting journal entry is done each month, and at the end of the year, when the lease agreement has no future economic benefits, the prepaid rent balance would be 0.
Example #2
Upon signing the one-year lease agreement for the warehouse, the company also purchases insurance for the warehouse. The company pays $24,000 in cash upfront for a 12-month insurance policy for the warehouse.
The initial journal entry for Company A would be as follows:
At the end of one month, Company A would have used up one month of its insurance policy. Therefore, prepaid insurance must be adjusted:
Note: One month corresponds to $2,000 ($24,000 x 1/12) in insurance policy.
The adjusting journal entry is done each month, and at the end of the year, when the insurance policy has no future economic benefits, the prepaid insurance balance would be 0.
Effect of Prepaid Expenses on Financial Statements
The initial journal entry for a prepaid expense does not affect a company’s financial statements. For example, refer to the first example of prepaid rent. The initial journal entry for prepaid rent is a debit to prepaid rent and a credit to cash.
These are both asset accounts and do not increase or decrease a company’s balance sheet. Recall that prepaid expenses are considered an asset because they provide future economic benefits to the company.
The adjusting journal entry for a prepaid expense, however, does affect both a company’s income statement and balance sheet. Refer to the first example of prepaid rent. The adjusting entry on January 31 would result in an expense of $10,000 (rent expense) and a decrease in assets of $10,000 (prepaid rent).
The expense would show up on the income statement while the decrease in prepaid rent of $10,000 would reduce the assets on the balance sheet by $10,000.
More Resources
Thank you for reading CFI’s guide to Prepaid Expenses. To keep learning and advancing your career, the following CFI resources will be helpful:
CFI is a global provider of financial modeling courses and of the FMVA Certification. CFI’s mission is to help all professionals improve their technical skills. If you are a student or looking for a career change, the CFI website has many free resources to help you jumpstart your Career in Finance. If you are seeking to improve your technical skills, check out some of our most popular courses. Below are some additional resources for you to further explore:
CFI is a global provider of financial modeling courses and of the FMVA Certification. CFI’s mission is to help all professionals improve their technical skills. If you are a student or looking for a career change, the CFI website has many free resources to help you jumpstart your Career in Finance. If you are seeking to improve your technical skills, check out some of our most popular courses. Below are some additional resources for you to further explore:
Below is a break down of subject weightings in the FMVA® financial analyst program. As you can see there is a heavy focus on financial modeling, finance, Excel, business valuation, budgeting/forecasting, PowerPoint presentations, accounting and business strategy.
A well rounded financial analyst possesses all of the above skills!
Additional Questions & Answers
CFI is the global institution behind the financial modeling and valuation analyst FMVA® Designation. CFI is on a mission to enable anyone to be a great financial analyst and have a great career path. In order to help you advance your career, CFI has compiled many resources to assist you along the path.
In order to become a great financial analyst, here are some more questions and answers for you to discover:
Take your learning and productivity to the next level with our Premium Templates.
Upgrading to a paid membership gives you access to our extensive collection of plug-and-play Templates designed to power your performance—as well as CFI's full course catalog and accredited Certification Programs.
Gain unlimited access to more than 250 productivity Templates, CFI's full course catalog and accredited Certification Programs, hundreds of resources, expert reviews and support, the chance to work with real-world finance and research tools, and more.