What is a prepaid expense?

A prepaid expense refers to a payment made for an expense that pertains to a future period. This accounting concept arises when a business pays in advance for goods or services that will be consumed or utilized over time.

For instance, if a company pays its insurance premium for the next year in advance, it records this payment as a prepaid expense. This is because the expense relates to future benefits rather than the period in which it was paid. Over the course of the year, as the insurance coverage is utilized month by month, the prepaid expense is gradually recognized as an expense on the income statement.

This treatment ensures that expenses are matched to the periods in which the related benefits are realized, in accordance with the accrual basis of accounting. Thus, understanding prepaid expenses is crucial for accurately portraying a company's financial position and performance in its financial statements.