What are Prepaid Expenses?
Prepaid Expenses refer to payments made in advance for products or services expected to be received on a later date — most often related to utilities, insurance, and rent.
Prepaid Expenses Accounting Examples
Initially, the payment made in advance is recorded as a current asset, but the carrying balance is reduced over time on the income statement per GAAP accounting standards.
Despite the “expense” in the name, the company receives positive economic benefits from the expense over the course of several periods, hence its classification as a current asset.
Under the matching principles of accrual accounting, revenue and expenses must be recognized in the same period.
Forecasting in Financial Modeling
In a financial model, a company’s prepaid expense line item is typically modeled to be tied to its operating expenses, or SG&A expense.
However, if the connection between the upfront payments and operating expenses (SG&A) is unclear, the projection of the prepaid expense amount can be linked to revenue growth as a simplification.
A company’s prepaid expenses are usually minuscule in relative size and rarely have a significant impact on a company’s valuation — hence, the expense is often aggregated with the “Other Current Assets” line.
Prepaid Expense Balance Sheet Treatment
Are Prepaid Expenses a Current Asset?
The prepaid expense line item represents payments made in advance, so the current asset remains until the associated benefits are realized.
Given the categorization as a “current” asset, the benefits associated with the products or services paid for upfront are expected to be used within the next twelve months.
Once the benefits of the assets are gradually realized, the current asset is reduced as the asset is expensed on the income statement.
Comparable to the mechanics of a depreciation schedule, i.e. the actual cash outflow is not recognized in the period the capital expenditure (capex) was incurred but rather spread across its useful life, the prepaid expense asset incrementally declines until the balance eventually reaches zero.
Simultaneously, as the company’s recorded balance decreases, the expense appears on the income statement in the period corresponding with the coinciding benefit.
Prepaid vs. Accrued Expense
The prepaid expense line item stems from a company paying in advance for products/services anticipated to be used at a later date.
In contrast, accrued expenses are costs incurred by a company but not yet paid for, typically due to the absence of an invoice (i.e. waiting on the bill).
That said, the notable difference between a prepaid expense and accrued expense is the treatment on the balance sheet:
- Prepaid Expense → Current Asset
- Accrued Expense → Current Liabilities
Prepaid Insurance Coverage Example
One common example of an early prepayment is insurance coverage, which is often paid upfront to cover multiple future periods.
Here, we’ll assume that a company has paid for insurance coverage in advance due to the incentives offered by the provider.
If the company makes a one-time payment of $24,000 for an insurance policy with twelve-month coverage, it would record a prepaid expense of $24,000 on the initial date.
In the coming twelve months, the company recognizes an expense of $2,000/month — which causes the current asset recorded on the balance sheet to decrease by $2,000 per month.
- Initial Upfront Payment = $24,000
- Monthly Expense on Income Statement = $2,000
By the end of the twelve-month coverage period, the entire insurance benefits are delivered, the total expenditure was expensed, and the corresponding asset on the balance sheet declines to zero.