What is a prepaid expense?

A prepaid expense is any ordinary and necessary business cost that is paid before the goods or services are actually used. Because the business has not yet received the full benefit at the time of payment, the cost is treated as an asset on the balance sheet until it is gradually expensed. Prepaid expenses are common for contracts, subscriptions, and services that span multiple accounting periods.

How to categorize prepaid expenses

Record the initial payment as a Prepaid Expense (Asset) on the balance sheet.
Amortize or expense the cost over the period in which the benefit is received.
Move the appropriate portion to Operating Expenses each accounting period.
Review prepaid balances regularly to ensure they are accurate and up to date.
Keep contracts, invoices, and payment records to support the timing of expense recognition.

Examples of prepaid expenses

Rent paid in advance.
Insurance premiums paid upfront.
Annual software or SaaS subscriptions.
Maintenance or service contracts paid before services are delivered.
Advertising or marketing services paid in advance.
Prepaid licenses or permits.

Tax implications for prepaid expenses

Under accrual accounting, prepaid expenses are generally deducted over the period they apply to, not when paid.
Cash-based businesses may deduct prepaid expenses when paid, subject to IRS rules such as the 12-month rule.
Expenses must be ordinary, necessary, and directly related to business operations to be deductible.
Proper treatment of prepaid expenses prevents overstating expenses in a single period.
Prepaid expenses are reported according to the business’s accounting method on Schedule C or business tax returns.