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.
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What is the Definition of Prepaid Expenses?
If a company decides to pay for a product or service in advance, the upfront payment is recorded as a “Prepaid Expense” in the current assets section of the balance sheet.
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 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.
What are Examples of Prepaid Expenses?
The most common examples of prepaid expenses include the following:
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How to Find Prepaid Expenses on the Balance Sheet?
The “Prepaid Expenses” line item is recorded in the current assets section of the balance sheet.
For example, the following screenshot from the balance sheet of Tesla (TSLA) for fiscal year 2022 illustrates where to find prepaid expenses.
Note how the “prepaid expenses” are consolidated with “other current assets” in one line item, which is often the case.
Tesla Prepaid Expenses Example (Source: TSLA 10-K)
How to Forecast Prepaid Expense?
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.
In the operating assumptions section of a model, the ratio between prepaid expense and operating expenses (or SG&A) will be calculated for historical periods.
For the forecast period, the prepaid expense will be projected based on the percent assumption multiplied by the projected operating expenses (SG&A).
However, if the connection between 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 its valuation. Therefore, the expense is often aggregated with the “Other Current Assets” line.
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.
The prepaid expense appears in the current assets section of the balance sheet until full consumption (i.e. the realization of benefits by the customer).
Given the categorization as a “current” asset, the benefits associated with the products or services paid 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 Expense vs. Accrued Expense: What is the Difference?
The prepaid expense line item stems from a company paying in advance for products/services anticipated to be used later.
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 prepaid expense and accrued expense is the classification on the balance sheet (B/S):
- Prepaid Expense → Current Asset (<12 Months)
- Accrued Expense → Current Liabilities (<12 Months)
What is an Example of Prepaid Expenses?
One common example of an early prepayment is insurance coverage, 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.
