Prepaid expenses: paid now, used later

Paying ahead buys an asset, the right to something not yet used. Each month, move the part that has been used out of the asset and into expense.

Hone is a place to practise a career, one idea a day. This is one of its lessons, written out in full and free to read without an account.

What it is for

A year's insurance, 1,200, is paid in January. If all of it lands in January's expenses, January looks like a disaster and the next eleven months look better than they are. The owner compares months and draws the wrong conclusion.

How to think about it

On payment, debit a prepaid asset. Divide the payment by the number of months it covers. At each month-end, move one share to expense.

Worked example

1 Jan: Dr Prepaid insurance 1,200 / Cr Cash 1,200

Cash out, asset in. Nothing has been used yet.

Monthly share = 1,200 / 12 = 100

Twelve months of cover, so twelve equal slices.

31 Jan: Dr Insurance expense 100 / Cr Prepaid insurance 100

One month used. The asset shrinks, the expense grows, by one slice.

Prepaid left = 1,200 − 100 = 1,100

Eleven months of cover still to come, sitting on the balance sheet as an asset.

Your turn

A 1,800 payment covers six months. Write the line that gives one month's share.

Monthly share = 1,800 /  = 300

The trap

Expensing the whole payment on the day it leaves the bank. The cash did leave; the cover has not been used, and the expense belongs to the months that use it.

Practise prepaid expenses on HoneA question on it now, a coding challenge where there is one, and it is remembered for review. Free, no email needed.