A prepaid expense is an expense that is paid for in advance. Recurring expenses such as insurance and rent can be paid for with one payment that covers the cost of the expense for several months or even a year.
Often, businesses prepay expenses in this manner because they can receive a discount.
Prepaid expenses also provide a benefit to a business by relieving the obligation of payment for future accounting periods. In this manner, prepaid expenses are considered an asset.
Anything that has economic value to a business is considered an asset. Prepaid expenses are considered a prepaid asset because the item that is paid for in advance, such as the rent or insurance coverage, has monetary value. Prepaid expenses are also considered a current asset because they can be easily liquidated—the value can be realized or converted to cash in one year or less. However, every asset has a cost. The value of the prepaid asset is offset by the cost of the expense in each of the affected reporting periods.
Recording a prepaid expense is a multi-step process. The expense will be debited as an asset in a prepaid account, such as insurance or rent.
It will be credited for the same amount of the full expense in the cash account, from which the payment was drawn.
As the expense is used up, monthly incremental payments will be credited to the asset, and debited in the appropriate expense account, such as insurance expense or rent expense.
By the time the expense is fully used up, the asset value will have reached zero, and the expense will now total the full amount that was paid. In this manner, the asset entry and the expense entries will cancel each other out.