In finance, prepaid expenses are bills that are paid in advance. The most common types of bills that businesses prepay are for rent and insurance, but legal retainers are another kind of prepaid expense. Insurance is often paid up to a year in advance, while commercial rent could be prepaid for several months or even annually. For those beginning to learn accounting basics, prepaid expenses can seem confusing since they are to be recorded as assets on a company's balance sheet rather than be considered an expense.

The simple rule is that if expenses are paid before they are listed on a balance sheet, they must be classified as a prepaid expense under assets when it's time to list them. A balance sheet is also sometimes called a statement of condition. It's a summary of a company's current financial condition; basically, what a business is worth at any given time. If an expense such as insurance or rent is paid months ahead, but not listed as being taken care of, then the company's condition would be incorrectly represented.

Since a prepaid expense is a bill definitely taken care of financially, it becomes a value, or asset. The balance sheet includes two columns: assets and liabilities. Assets are what a company owns. Liabilities are what a business owes. The equity, or worth, of the company at any given time is calculated by subtracting the liabilities from the assets. Typical assets on a balance sheet include cash, accounts receivable and prepaid expenses such as rent. Liabilities include accounts payable and credit financing payments.

The reason that prepaid expenses must be listed on a balance sheet as an asset is that the company now has the benefit of the item. For example, if a business pays three months of rent in advance, it's then a paid asset even though it was a prepaid expense. The company doesn't have to pay rent again for three months, so that is a financial advantage as far as the balance sheet goes. It would be listed as prepaid rent on the balance sheet.

Although rent, insurance and legal retainers are common prepaid expenses for companies, there are many other possible advance payments that could qualify as a prepaid expense. For example, if an employee is paid early for some reason, that would read something like prepaid salary on the balance sheet. Both small and large businesses often have some types of prepaid expenses to record.

Both goods and services qualify for prepaid expenses. Anything of value that a company secures, whether it physically has the good or service now or will have it in the near future, must be recorded as a prepaid expense in the assets column of a balance sheet. This action can be rationalized as a company having the right to own the asset because it already paid for it.