In plain English
Insurance and annual software are common. Each month moves a share to expense.
Do not leave a prepaid balance after coverage ends.
Why it matters
If you expense a full year of insurance in the month you pay it, that month looks like a loss and the next eleven look better than they are. Spreading prepaid costs keeps monthly profit steady and comparable, which matters when you or a lender look at trends.
At year end, prepaid balances that were never used up overstate assets. Your accountant may also need to know about them when deciding how they are treated on the return.
Worked example
A $2,400 policy paid October 1: at December 31, $600 is expense and $1,800 remains prepaid.
How to handle it
- Record the full payment to a prepaid asset account rather than an expense account.
- Divide the cost by the number of months it covers to get the monthly amount.
- Set up a recurring monthly entry that moves that amount from prepaid to the matching expense.
- Keep a short schedule listing each prepaid item, its start date and its remaining balance.
- Confirm the schedule matches the prepaid account balance at each month end.
Common mistakes
- Forgetting to stop the monthly entry after coverage ends, which drives the prepaid account negative.
- Treating a refundable deposit, such as a lease security deposit, as a prepaid expense that gets used up.
- Spreading tiny annual charges over twelve months, which adds work without improving the numbers.
Not the same as: Deferred revenue
A prepaid expense is cash you paid before receiving a service, so it is an asset. Deferred revenue is cash a customer paid you before you delivered, so it is a liability. See Deferred revenue.
Go deeper
- Prepaid Expenses and Deferred Revenue Basics: How to book prepaid insurance, annual software and customer prepayments so income and expenses land in the right months on your reports.
- Prepaid Expenses and Accrued Liabilities at Year End: Learn how items paid early or owed but unpaid are handled at year end, and what records to keep for accrual-based books.
Related terms
- Purchase discount: A price reduction a vendor gives for paying early, such as 2/10 net 30.
- Retainage: A percentage of a construction or project payment held back until work is complete.
- Petty cash: A small cash fund for minor expenses, kept with receipts and replenished to a fixed amount.
Common questions
What is a prepaid expense?
A cost paid in advance that is recorded as an asset and expensed over the period it covers.
Can you give an example of prepaid expense?
A $2,400 policy paid October 1: at December 31, $600 is expense and $1,800 remains prepaid.
Should a cash basis business track prepaid expenses?
Many cash basis businesses expense payments when made. Whether and how to spread a prepayment can affect your return, so ask your accountant how they want it handled.
What happens if I cancel a prepaid service partway through?
Any refund reduces the prepaid balance. The unused part that will not be refunded is expensed at the time of cancellation, so the account does not carry value that no longer exists.
General information, not tax, legal or accounting advice. Confirm rules with the IRS, the NJ Division of Taxation or a licensed professional.