What are prepaid expenses in a balance sheet?

Prepaid expenses can be easy to overlook, but they have a real impact on how your balance sheet, income statement, and cash flow statement tell the story of your business. Whether it’s prepaid rent, insurance, or a year-long software subscription, these advance payments affect your financials long before the services are used.

In this guide, we’ll walk through what prepaid expenses are, how to record them, and where they appear across your financial statements. You’ll also learn how they affect working capital, tax treatment, and your cash flow under accrual accounting.

What are prepaid expenses?

Prepaid expenses are costs a business pays upfront for products or services it will receive or use in future accounting periods. Rather than recording the entire amount as an immediate expense, companies list these payments as current assets on the balance sheet. Over time, the prepaid amount is gradually transferred from the balance sheet to the income statement as the benefit is realized.

This approach aligns with accrual accounting and the matching principle, which require businesses to recognize expenses in the same period as the revenues they help generate.

Prepaid expenses are especially common in industries with long-term vendor contracts, recurring services, or annual subscriptions. When managed properly, they improve the accuracy of both profitability metrics and working capital calculations: two essentials for scaling businesses.

Why prepaid expenses show up on the balance sheet

Prepaid expenses appear on the balance sheet because they represent future economic benefits. In other words, the business has paid for something it hasn’t received yet. Until that good or service is delivered or used, the payment isn’t considered an expense. Instead, it’s an asset. More specifically, prepaid expenses fall under the category of current assets, which includes items a company expects to use or convert into cash within a year.

This treatment is essential for maintaining compliance with accrual accounting standards and Generally Accepted Accounting Principles (GAAP). The core idea is that companies shouldn’t recognize an expense until it has been incurred. By recording prepayments as assets, businesses avoid inflating expenses in one period and underreporting them in the next. This keeps the financial statements accurate and aligned with the actual timing of economic activity.

This monthly adjustment is called amortization of the prepaid expense, and it continues until the full amount has been recognized as an expense. The balance sheet updates accordingly, with the prepaid asset decreasing each period while the corresponding expense increases.

Understanding this flow is critical for businesses that want to maintain an accurate view of their working capital—the difference between current assets and current liabilities. If prepaid expenses weren’t recorded properly, the business might appear less liquid or overstate its profitability for a given period. 

Accurate classification also matters for liquidity ratios, because prepaid expenses working capital adjustments can shift your current-ratio calculation.

Common examples of prepaid expenses

Most businesses encounter prepaid expenses regularly, especially when they lock into annual contracts or pay vendors upfront to secure services. While the category may sound niche, it covers a wide range of routine costs. The common thread: payment is made now, but the benefit is received over time.

Here are some of the most common types of prepaid expenses, how they’re typically used, and how they’re accounted for:These expenses can vary in size, but they’re all treated the same way: as assets first, and expenses later.

Another nuance worth noting: some prepaid expenses are easily predictable and occur regularly (like rent or insurance), while others may be one-off or tied to irregular business activities (like a marketing campaign or annual audit). Regardless of frequency, all should be tracked with consistent rules and recognition schedules to avoid distortions in your financial reporting.

When in doubt, finance teams should ask two key questions:

1. Has the service or product been delivered yet?
2. Will the benefit extend across multiple accounting periods?

If the answer to both is yes, it’s likely a prepaid expense and should be handled accordingly.

Is prepaid rent an asset? What about prepaid insurance?

Yes, both prepaid rent and prepaid insurance are considered assets on the balance sheet. More specifically, they’re classified as prepaid expenses, which fall under the broader category of current assets. But there’s an important nuance: while they are technically assets, they’re not liquid or spendable like cash.

Let’s break it down:

Prepaid rent

If your business pays rent in advance, it hasn’t yet received the full benefit of that space. Until each month passes and your team occupies the space, that rent payment remains a prepaid asset. You can’t “get the money back” easily, nor can you use it to pay another bill, but it still represents economic value.

Over time, the prepaid rent balance on your balance sheet declines as you record rent expense each month. This process ensures that your income statement reflects the true cost of occupancy as the benefit is received, not before.

Accounting treatment:

• Month of payment: debit prepaid rent (asset), credit cash
• Each following month: debit rent expense, credit prepaid rent

Prepaid insurance

This works similarly. Most commercial insurance policies are paid annually but protect over 12 months. That means only 1/12 of the cost is actually “used” in any given month.

Just like rent, prepaid insurance reflects a future economic benefit, which qualifies it as an asset under GAAP.

But are prepaid rent and insurance liquid assets?

Not quite. While repaid rent and insurance are current assets, they aren’t liquid. You can’t easily convert a prepaid rent contract or insurance policy back into cash without penalty or loss. 

That’s why prepaid expenses appear on the balance sheet and are included in the current ratio, but they’re excluded from more conservative measures like the quick ratio, since they can’t be easily converted to cash.

So, the answer to common questions like:

• Is prepaid rent an asset? → Yes, it’s a current asset.
• Is prepaid insurance an asset? → Also yes, treated the same way.
• Are prepaid taxes or prepaid advertising assets? → Yes, if paid in advance and benefit spans multiple periods.

Note that prepaid rent appears in the current-asset subsection of the balance sheet, grouped with other prepaid expenses.

How to record prepaid expenses (with journal entries)

Properly recording prepaid expenses is essential to ensure your financial statements reflect the correct timing of costs. The process involves two key accounting steps: the initial recognition of the prepayment and the gradual amortization of that expense over time.

Let’s break this down with an example.

Step 1: Record the prepayment

When the business pays for a good or service in advance, you record the full amount as a prepaid expense (asset). This reflects the value the company expects to receive in the future.

Journal entry at the time of payment:

This entry increases your assets (prepaid rent) and reduces cash, without affecting the income statement yet.

Step 2: Amortize the expense over time

Each period, you recognize a portion of the prepaid asset as an actual expense, moving it from the balance sheet to the income statement. This ensures the cost aligns with the period in which the benefit is received.

Monthly adjusting entry (for a 12-month lease):

Repeat this process each month until the full prepaid amount is expensed and the prepaid asset balance reaches zero.

Same logic applies to other prepaid categories

Whether you're dealing with prepaid insurance, advertising, subscriptions, or retainers, the structure is the same:

1. Debit a prepaid asset account at the time of payment.
2. Credit the corresponding expense account as you realize the benefit over time.

Why prepaid expense accuracy is important

Accurate journal entries for prepaid expenses help:

• Maintain compliance with GAAP
• Avoid misstated income or working capital
• Ensure accurate month-end close
• Support audit readiness with clear amortization schedules

It also helps avoid over-reporting expenses in a single month, which could skew profitability, financial ratios, or tax planning decisions. For companies managing large contracts or multiple recurring prepayments, automating these entries through software can significantly reduce manual errors and accounting workload.

How prepaid expenses affect your cash flow statement

While prepaid expenses primarily live on the balance sheet, they also impact the cash flow statement, especially if you use the indirect method of reporting cash from operating activities.

Here’s how it works:

The timing mismatch

When a business prepays for something like insurance or rent, cash goes out immediately. But under accrual accounting, that payment isn’t recognized as an expense until later. This creates a temporary disconnect between cash flow and net income.

The indirect method of adjustment

Most companies use the indirect method to calculate cash flow from operating activities. This method starts with net income and adjusts for non-cash transactions, including changes in working capital accounts like prepaid expenses.

If your prepaid expenses increase during the period, that means the company spent cash without recognizing an expense, so the adjustment reduces operating cash flow.

Example adjustment:

• Increase in prepaid expenses → Subtract from net income
• Decrease in prepaid expenses (as they’re amortized) → Add back to net income

A sudden spike in prepaid balances can create a cash squeeze that isn’t immediately obvious on the income statement.

Tax treatment of prepaid expenses under IRS rules

Understanding prepaid expenses tax treatment is essential because book rules and IRS rules diverge. While your books might amortize a prepaid cost evenly across multiple periods, the IRS may require a different timeline, depending on the type of expense, amount, and length of the benefit period.

Understanding this distinction is essential for staying compliant and avoiding surprises during tax season.

The IRS 12-month rule

The IRS’s 12-month rule is a key guideline that determines whether a prepaid expense can be deducted in full or must be spread out over time. According to this rule, you can deduct the full amount of a prepaid expense in the year it’s paid if:

1. The benefit lasts 12 months or less, and
2. The benefit doesn’t extend beyond the end of the following tax year

The de minimis rule for small prepayments

There’s one exception that offers flexibility: the de minimis safe harbor. If the total prepaid expense is $5,000 or less, and the benefit is used within 12 months, the IRS may allow you to deduct the full amount in the year it’s paid.

This rule helps small businesses avoid unnecessary complexity when managing routine vendor payments that don’t cross fiscal boundaries.

Book income vs. taxable income

The way you treat prepaid expenses for financial reporting often differs from how you handle them on your tax return. This creates a temporary difference between book income (used for financial statements) and taxable income (used for IRS reporting).

These timing differences can lead to deferred tax assets or liabilities, which are tracked separately and disclosed in your financial reports if material.

Prepaid vs. accrued expenses

Prepaid expenses and accrued expenses are often confused, but they’re financial opposites. Both relate to timing differences between cash movement and expense recognition, but they occur on opposite ends of the transaction lifecycle.

Here’s the simple breakdown:

Prepaid Expenses

• Paid in advance for a future benefit
• Recorded as a current asset
• Cash out first, benefit received later
• Examples: prepaid rent, prepaid insurance

Accrued Expenses

• Incurred but not yet paid
• Recorded as a current liability
• Benefit received first, cash out comes later
• Examples: wages payable, utilities owed

Prepaid expenses: asset first, expense later

When a business pays upfront for a product or service, it records that payment as a prepaid asset. Over time, the cost is moved to the income statement as the benefit is realized.

Accrued expenses: liability first, payment later

Accrued expenses work in the opposite direction. When a business uses a service but hasn’t yet been invoiced or hasn’t paid, it creates an accrued liability.

You record wages payable in December to reflect the cost in the right period
When you pay in January, the liability is cleared

Best practices for managing prepaid expenses

Prepaid expenses might seem straightforward, but managing them well requires more than just recording a one-time payment. If not tracked carefully, they can quietly distort your income statement, overstate your assets, or disrupt your month-end close.

Here are some best practices to help your team stay on top of prepaid expenses—and avoid costly accounting surprises:

1. Set up automated amortization schedules

Manually adjusting prepaid expenses each month can be time-consuming and error-prone. Instead, use accounting software to create recurring amortization schedules tied to the original payment date and contract terms. These schedules ensure that expenses are recognized evenly over time and eliminate the risk of skipped or delayed journal entries.

2. Categorize prepaid expenses consistently

Not all upfront payments are true prepaids. A one-time purchase that provides an immediate benefit should be expensed right away. But anything that spans multiple periods should be categorized as a prepaid asset. Clear rules and training for your team can help prevent miscoding.

3. Track large or unusual prepayments separately

High-dollar prepaid expenses (e.g. $50K for annual advertising or software retainers) should be monitored closely, especially if they cross fiscal years. Set reminders for renewal dates and create visibility into upcoming amortization impacts so there are no surprises at year-end.

4. Align amortization with financial reporting cycles

To streamline your month-end close, make sure all prepaid amortization entries are booked before generating financial reports. This ensures your balance sheet and income statement are in sync, and reduces last-minute adjustments that delay reporting.

5. Reconcile prepaid balances regularly

At least quarterly (and ideally monthly), compare your prepaid asset accounts against amortization schedules and actual service usage. This reconciliation step helps catch overstatements, expired contracts, or missed adjustments before they snowball.

Track and automate prepaid expenses with Rho

Done right, prepaid expense management becomes a routine, automated part of your accounting workflow, not a monthly fire drill. And the payoff is real: faster closes, cleaner audits, and more accurate financial visibility.

Finance teams that manage prepaid expenses well benefit from cleaner books, better cash flow visibility, and faster closes. 

Get started with Rho to streamline prepaid expense management and keep your balance sheet accurate and compliant in every reporting cycle.

FAQs about prepaid expenses

Where do prepaid expenses appear in the section of the balance sheet?

They sit under current assets, often labeled “prepaid expenses on balance sheet” or simply “prepaid assets.” So, yes, prepaid expenses appear in the section of the balance sheet right after cash and receivables.

Which accounts would be considered a prepaid expense or prepaid asset account?

Prepaid accounts (also called prepaid expenses) are: prepaid insurance, prepaid rent, prepaid advertising (answering “prepaid advertising is what type of account?”), prepaid software, and prepaid taxes. Any prepayment that provides a future benefit belongs here.

How are prepaid expenses recorded and amortized?

Standard prepaid expense journal entries start with “debit prepaid, credit accounts payable” or cash. Each month you post a prepaid amortization entry that moves a slice to expense, because prepaid expenses reflect transactions when cash is paid, not when the expense hits the P&L.

Accountants may also write the initial entry as debit prepaid credit accounts payable when the invoice remains open.

How do prepaid expenses affect ratios and cash flow?

They’re excluded from the quick ratio (answering “is inventory a quick asset”… likewise, prepaid expenses are not). On the indirect cash-flow statement, you’ll see “prepaid expenses on cash flow statement”; increases reduce operating cash. Remember: prepaid expenses classified as current assets represent payments of expenses that will benefit more than one accounting period—the flip side is prepaid income, a liability when you’re paid before earning revenue.

Is prepaid rent a current asset, and what is its normal balance?

Yes, prepaid rent is a current asset because it represents a payment made for future use of property or space. On the balance sheet, its normal balance is a debit, which increases the asset account. As the rental period passes, the prepaid rent is gradually expensed through amortization.

Do prepaid expenses affect liquidity ratios?

While prepaid expenses are current assets, they don’t qualify as liquid assets and are excluded from the quick ratio. That’s because they can't be quickly converted to cash or used to pay short-term liabilities.

Does GAAP have a threshold for prepaid expenses?

GAAP does not prescribe a universal dollar threshold for prepaid expenses. Instead, companies often set internal materiality thresholds—for example, only capitalizing prepaids over $2,500 or $5,000. The key requirement is that the expense provides a future economic benefit extending beyond the current period.