Prepaid Expenses Explained: What They Are and How to Account for Them
- Thinking Ledger
- Jul 11
- 3 min read
Prepaid expenses often confuse startup founders — “If I’ve already paid for it, isn’t it just an expense?” Not always.
In this article, we’ll break down what prepaid expenses are, how to record them properly, and why handling them right helps your books reflect true financial health.
What Are Prepaid Expenses?
Prepaid expenses are payments made in advance for goods or services to be received in the future. Instead of recording them as immediate expenses, they’re treated as assets on the balance sheet and expensed over time.
Example: You pay $6,000 on January 1st for a 12-month software subscription. Instead of expensing the full $6,000 in January, you record $500/month for 12 months.
Accounting Treatment (Accrual Basis)
Under GAAP accrual accounting, expenses are recorded in the period they’re incurred, not when cash is paid.
This means:
● When you prepay, it’s an asset.
● As time passes and the service is used, it becomes an expense.
Accounting Entries:
On January 1 (payment made):
Dr Prepaid Expense (Asset) $6,000 Cr Cash/Bank $6,000
On Jan 31 (1 month used):
Dr Software Expense (P&L) $500
Cr Prepaid Expense (Asset) $500
Repeat each month until the balance is zero.
Relevant GAAP Reference: ASC 340 – Other Assets and Deferred Costs
Common Prepaid Expense Categories for Startups
💡 Tip: Create a prepaid schedule to track what’s left and when to expense it.
How to Track Prepaid Expenses (with Template)
To avoid missing entries or overstating profit in early months, use a simple tracker like this:
Want this as a Google Sheet template? Let me know — I can send it over!
Tax Note: Cash vs. Accrual
If you’re using cash basis accounting (typical for very early-stage startups), you may expense the full payment immediately.
But once you switch to accrual (often required after revenue thresholds), you must follow the proper matching principle.
IRS Form 3115 is used to switch accounting methods in the U.S.
Why Prepaid Expenses Matter for Accurate Financials
Failing to account for prepaid expenses correctly can lead to:
Overstated expenses in the current period
Understated net income, affecting KPIs
Misleading burn rate and runway projections
Investor distrust when they spot inconsistencies in reports
Visual Illustration: Prepaid Expense Flow
Payment → → → → →
┌────────┐ ┌────────┐ ┌────────┐ ┌────────┐
Month: | Jan | | Feb | | Mar | | Apr |
└────────┘ └────────┘ └────────┘ └────────┘
[Asset ↓] ↓ Exp ↓ Exp ↓ Exp
$6,000 paid → $500/mo expensed
🧠 Think of prepaid expenses like an orange: you’re peeling and consuming it month by month.
Founder FAQs
Q: Do I have to manually adjust every month? A: Ideally yes, but many accounting platforms allow recurring journal entries or amortization schedules to automate this.
Q: What happens if I cancel a prepaid subscription mid-term? A: You'll reverse the remaining prepaid balance and recognize the refund as income or offset future expenses.
Final Takeaway
Understanding and tracking prepaid expenses isn't just good practice — it’s essential for accurate reporting, investor confidence, and financial clarity. It also ensures you don’t overpay taxes or misrepresent your profitability.
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