What You Need to Know About Prepaid Expenses When Doing Your Bookkeeping

Some vendors require their clients to prepay for certain expenses. Other vendors offer discounts on materials or services to customers who are willing to upfront. Individuals and businesses may also independently choose to prepay for expenses in order to get them out of the way and not have to worry about keeping up with regular payments. Here’s how to handle prepaid expenses to make bookkeeping easier.

Types of prepaid expenses

When a customer pays for goods or services before receiving them, the costs are considered prepaid expenses. Insurance policy premiums, rental and lease payments, and legal and accounting retainers, are common types of prepaid expenses. 

How to treat prepaid expenses

Prepaid expenses are treated as current assets on the balance sheet. A bookkeeper first needs to ensure they have a proper prepaid expense account record to enter the required information. Such prepaid account records are easy to create with cloud-based bookkeeping software, such as Xero and QuickBooks.

At the end of an accounting period, typically monthly, quarterly and yearly, the bookkeeper records the use of the goods and services. They’ll do this by debiting the appropriate expense account and crediting the prepaid expense account. Below are four examples of common prepaid expenses and how a business owner accounts for them when doing the books:

Prepaid expense bookkeeping examples

Insurance policy 

Let’s say a company purchases a $2,400 insurance policy in December 2022 for the following year. The policy covers the business from January 1, 2023, until December 31, 2023.

When the bookkeeper is preparing January 2023 month-end journal entries, they debit the “insurance expense” account and credit the “prepaid insurance” account for the amount of insurance coverage used in January 2023, which is $200, as $2,400 per year divided by 12 months is $200 per month.

Office lease

Let’s say a business is offered a 15% discount on office space if it pays the full 12-month lease upfront, rather than a portion each month, for a total of $24,000 including the discount. The business decides to take the 15% discount as it is greater than the business’s cost of capital. The bookkeeper then records journal entries of $2,000 for each of the next 12 months to account for the rental expenses, since $24,000 over 12 months is $2,000 per month.

Equipment lease

Let’s say a business leases a piece of heavy equipment for 3 months to use on a recently won contract. The leasing company requires short-term leases to be paid in full upfront. The business owner pays $30,000 upfront for its use over the next 3 months. At the end of each month, the bookkeeper should record the use of the equipment by debiting the “equipment expense” account and crediting the “prepaid equipment” account. 

Legal retainer

A legal retainer is a fee that a business prepays for anticipated legal services. Retainers are required by lawyers to ensure that their clients have the ability to pay for their services. A lawyer draws from the prepaid retainer fee when services are provided for the client.

At the end of each month, the lawyer provides a summary of the hours spent and the associated costs of the legal services provided. The business’ bookkeeper then takes the costs reported, and creates a journal entry debiting “legal expenses” and crediting “prepaid legal services”. 

Need an accountant? Read more about How to Choose a Chartered Accountant in Canada.