Prepaid expenses are payments made for expenses which have not yet been consumed.
Because prepaid expenses reflect goods or services which are owed to the company, prepaid expenses are recognized as assets. Prepaid expenses are generally recognized as current assets, since most prepaid expenses are consumed within one year. However, some expenses may be prepaid for a period beyond one year, in which case the prepaid expense is separated into a current and noncurrent portion.
Common examples of prepaid expenses include insurance, rent, and professional fees (retainers).
As the expenses are consumed, the company credits prepaid expenses and debits the relevant expense account. In other words, the company ‘transfers’ prepaid expenses to operating expenses as the expenses are consumed.
Consider the following example. A company purchases general liability insurance on January 1 for $36,000. The insurance covers the company for the next twelve months. How should the company account for this transaction?
The company accounts for the initial payment by debiting a current asset account called prepaid expenses and crediting cash. At the end of each month, the company recognizes the consumption of the expense by debiting insurance expense and crediting prepaid expenses. Each month, the company will recognize 1/12th of the prepaid insurance, or $3,000 per month. At the end of the year, the prepaid insurance will be completely recognized in insurance expense.