What are Prepaid Expenses?

In finance, prepaid expenses are goods or services that people pay for in advance. Accountants treat them as assets on personal or business balance sheets, and tracking them accurately is important because of their ability to affect the perception of worth. People handle transactions in this way for many different reasons, such as the ability to receive a discount, and they usually can do so with traditional methods, such as offering a check. Handling these types of expenses electronically is becoming the norm, however, because it saves both time and additional resources.

Both goods and services — and essentially, virtually anything of value — can be a prepaid expense. Common examples are rent, insurance and legal retainers, but people often cover utilities, such as electricity or heat, as well. Another instance is when consumers buy a product before it is released into stores.

An asset is defined as anything a person or company owns that has value. When people or businesses buy something in advance, they acquire ownership or access rights, so despite their label, accountants see prepaid expenses as assets. The exact benefit varies, but the assumption is always that the buyer will find some advantage in the purchase.

Normally, an accountant uses a document called a balance sheet to show all the assets and liabilities a business or individual has, usually using two simple columns. He treats prepaid expenses as having value, so he records them in the asset column with other items the person or company owns. By subtracting the liabilities from the assets, he can figure out overall equity, so properly reporting and tracking what is purchased ahead of time can affect the appearance of worth. People generally consider inaccurate representation of value as problematic, especially when it is intentional and misleads investors and lenders.

People sometimes prepay for something because doing so will give them a discount or other benefit. An insurance company, for example, might change $600 USD for a policy if a person makes payments every month, or they could charge $550 for paying in full with a single payment at the start of the contract. Some individuals also like the convenience, as it can mean less time handling bills, fewer transactions and more flexibility in terms of being able to travel.

Another reason for giving money in advance is that a person wants some guarantee that the product or service will be available in the future. A fashion designer, for instance, could pay a model upfront to make sure she will participate in an upcoming show. The higher the demand for something is, or the lower the supply, the more likely it is that people will want this kind of guarantee.

Some individuals also buy early because they aren’t sure whether they’ll have the funds to make the purchase later. Psychology sometimes comes into play here, because the way a person perceives his financial situation changes the degree of urgency he assigns to an early payment. Some people assume the worst and pay ahead of time even when they don’t really need to, for instance, while others deny how dire their money circumstances are and end up missing or ignoring payments. Creating and sticking to a good budget is a way to keep what’s happening in proper perspective.

Typically, people can handle prepaid expenses the same way as they do regular expenses. Traditional payment methods include cash, check and money orders, which are either sent by mail or hand delivered to the recipient. These techniques are well-known, but they usually are fairly time consuming and can consume other resources, such as the gasoline needed to take a vehicle to a bank or vendor’s store.

Increasingly common are electronic transactions, which use computer-based systems to move money from one account to another. Examples are wire transfers and electronic debits. These usually can be completed much more quickly, but they have their own disadvantages, such as the need for continued technology upgrades and support and the high risk of information theft.

Even though many different methods are available, the ones that are acceptable vary from vendor to vendor or company to company. Many businesses, for example, won’t accept certain credit cards because of the expenses associated with processing a transaction with that company, and some won’t take cash payments by mail because of the risk of theft and loss. When someone isn’t sure what method to use, it’s usually best to call a representative and ask, or to check prepayment policies on the company website.