Prepaid Expenses

Prepaid expenses belong on the balance sheet and can encompass costs such as rent, insurance, advertising, and any other cost that normally would be expensed on your income statement but is paid in advance of the period in which it is owed. Prepaid expenses differ from deposits as they will be used up within a specific period (usually within a year) as a deposit could be carried until the end of a contract when ever that might be. For example, prepaid rent would be an upfront prepayment of the yearly rent, but a rental deposit would be tied in with certain contract obligations and not be an actual expense until the end of the contract.

Should you, for example, pay for your yearly insurance premium in one lump sum then you would charge this premium to an account called Prepaid Insurance. The entry would be:

Debit: Prepaid Insurance Expense $(amount of yearly premium)

Credit Accounts Payable or Cash $(amount of yearly premium)

(Depending on method of payment)

Each month a general journal entry would be made expensing one month's premium cost. This entry would be as follows:

Debit: Insurance Premium Expense $(1/12 of yearly premium)

Credit Prepaid Insurance Expense $(1/12 of yearly premium)

Handling prepaid expenses in this way assures you are following the rule of matching revenue with expense. You can see if you were on a calendar fiscal year ending December 31st, and your insurance premium was due on November 1st to expense the entire premium in November would be inappropriate.

Although, an insurance premium is the most common prepaid expense, there are several others that you might come across. Anytime you pay an expense, no matter what type, that will have a timing effect on your books; you should consider using a Prepaid Expense account on your balance sheet for that expense.