The financial accounting term prepaid expense refers to the portion of an advance payment that has not been used up at the end of an accounting period. Prepaid expenses are an asset and appear on a company's balance sheet.
Oftentimes, businesses will enter into agreements with vendors or purchase supplies that have been paid in full but are not consumed in the current accounting period. Examples of prepaid expenses include insurance policies, office supplies, and maintenance agreements.
Accounting for prepaid expenses follows the matching principle, which states that revenues generated in an accounting period need to be matched with the expenses incurred in that same accounting period.
The unused portion of a prepaid item provides future economic benefit to the company and appears as an asset on the company's balance sheet. As the economic benefit of the prepaid item is used up over time, the asset account is reduced and a corresponding expense appears on the company's income statement.
On July 1, Company A purchases a maintenance agreement on their call center's backup generator. The agreement is for a term of 24 months, and the upfront cost is $12,000. At the end of the year, Company A would have booked an operating expense of $12,000 / 24 months, or $500 per month times six months or $3,000 to the income statement. Company A would have a prepaid asset on their balance sheet of $12,000 - $3,000, or $9,000.