What is a prepaid expense?

A prepaid expense is an asset that appears on the balance sheet as a result of making advance payments for goods and services to be received within the next 12 months. The actual expense is recognized on the income statement once the business receives the benefit. First, let’s identify what a prepaid expense is not. Any expense that has been consumed before making payment cannot be a prepaid expense. Such expenses can be electricity, wages, professional services, telephone, equipment repairs, etc. Prepaid expenses are often recorded from professional retainers, annual insurance premiums, annual subscriptions, auto and equipment leases, or networking membership dues to name just a few.

Why does this matter? What is the relevance to me as a business owner? Simply put, it plays a crucial role in producing accurate financial statements. Prepaid expenses allow the business owner to recognize expenses in the same period they receive the benefit. Without the option of recognizing some cost payments as prepaid expenses, the financial reports would not accurately reflect the financial performance and position of the business month over month. This can lead to poor decision making and ultimately, an ineffective business.

Written by:
Adriat Markos
TGG Accounting

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