Anyone who has rented an apartment or paid for car insurance should be familiar with the concept of prepaid expenses — paying upfront for goods or services they will receive later, over time. Businesses do this all the time. But unlike individuals, businesses must follow accounting rules that complicate the transaction beyond simply writing a check or initiating a digital payment. Why? Because that prepayment is an asset that has value beyond the present time.
As a result, businesses that follow the accrual method of accounting use amortization as a way to spread prepaid expenses over the accounting periods in which the business will derive value from them. And since accrual accounting is the basis for financial statements that a lender, regulator or potential partner would likely require, it’s important to understand prepaid expenses and the related amortization. It’s not complex, but it can be tedious and time-consuming.
What Are Prepaid Expenses?
A prepaid expense is an asset that is created when a business pays for a product or service before receiving it. Upfront payments are a common scenario, such as for rent, insurance, legal services and more. Sometimes businesses prepay as a term of the business transaction. Other times businesses opt to pay in advance to capture discounts — aptly called “prepay discounts.”
The bookkeeping for prepayments is easy for businesses that use cash-basis accounting: Simply record the entire amount as an expense when the cash is paid. But that can be hard on the business’s income statement, since the entire — often large — expense hits all in one period, potentially causing confusing swings in profitability. Accrual basis accounting requires a different approach. In this method, the prepayment is capitalized as an asset and then amortized. This treatment is a bit more complicated but does a better job of reflecting the expense in the periods the expense will cover.
- A prepaid expense is an asset arising from when a business pays for a product or service in advance of receiving it, such as upfront payments for rent, insurance, software and many others.
- Amortizing the prepaid expense matches expenses to the right period in accordance with Generally Accepted Accounting Principles (GAAP).
- Each prepaid expense is unique based on its underlying transaction and requires analysis to create an appropriate amortization schedule.
- The right accounting software can maintain a prepayment register, generate the related amortization schedules and automate the adjusting journal entries, making the accounting close more efficient and less susceptible to error.
Prepaid Expense Amortization Explained
Prepaid expenses represent future economic value, which is why they are initially recorded as an asset on a company’s balance sheet. As the asset is used, the amount consumed is recognized as an expense on the income statement by using a convention called amortization. (Together, the balance sheet, income statement and cash flow statement are the three most important financial statements for small businesses.) Amortization is the systematic “writing down” of an asset during the time period when the asset benefits the business. Over time, the prepaid expense asset becomes smaller and the accumulated amount of the recognized expense becomes larger.
Amortization schedules are set up to show how a prepaid expense will be amortized over time, based on the unique characteristics of the transaction. Most often, prepaid expenses are amortized using the straight-line method, which evenly spreads the expense over the period of benefit. For example, an amortization schedule for a six-month insurance premium would show one-sixth of the premium being transferred to insurance expense each month for six months. Sometimes it may be more accurate to use a different method of amortization depending on the nature of the prepaid expense. For example, it may be more appropriate to align the amortization of prepaid advertising costs with the months the campaign is expected to run, even though the advertising might deliver benefits to the business long after the campaign is complete.
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Types of Prepaid Expenses
Businesses prepay many types of expenses. In all cases, the prepaid expense represents an asset to the company because it has future economic value. However, how that asset is classified on the balance sheet and the method used to amortize it vary depending on the duration for which value is received and the nature of the transaction. Prepaid expenses that are expected to be used up within one fiscal year are reflected as current assets on a balance sheet, affecting working capital. Prepaid expenses that span multiple years are considered long-term assets — mostly. The portion of a long-term prepaid expense that is expected to be used within one year is classified as a current asset and the remainder that extends beyond one year is classified as a long-term asset.
Common types of prepaid expenses include:
Rent:Property owners often require renters to make cash payments in full at the beginning of a rental agreement. For the renting business, this advance payment is a prepaid expense because it has not yet occupied the space for the entire time covered by the payment. For example, an annual rental agreement may be paid in a single installment in January, causing the remaining 11 months to be set up as a prepaid rent asset.
Insurance:Insurance premiums are often structured in six- or 12-month coverage periods, paid in advance. When the payment is made, the premium represents a prepaid expense for the policyholder because they have not yet received the insurance coverage for the entire period. A prepaid insurance asset is valued as the prorated portion of the unexpired insurance premium.
Advertising:The cash a business pays for an advertising campaign that has yet to begin or is still running is considered a prepaid expense for the advertiser and reflected as an asset on its balance sheet. Prepayment is commonly required in order to reserve advertising space. But the expense should be recognized when the ads run, not when they are paid. A prepaid advertising expense would be reflected as an asset on the balance sheet until that time.
Other:Prepayments are common in business and there are many other types. The details of each situation are unique, but the accounting follows the same three-step pattern: Make an advance payment, establish an asset for the prepaid expense and amortize it over the period of consumption. Some examples of other prepaid expenses are subscriptions, professional services fees, supplies, software licenses, maintenance contracts, taxes and utilities.
Because it’s impossible to include a comprehensive list of every possible prepaid expense scenario, it’s more useful to understand the concept in order to identify transactions that create prepaid expense assets.
Amortization of Prepaid Expenses in Business Accounting
Amortizing a prepaid expense, rather than expensing it all at once, makes a business’s financial statements more accurate. Amortization is the method for apportioning payments over the fiscal periods in which they have an impact, a requirement for compliance with accounting’s matching principle, which is one of the key tenets of U.S. Generally Accepted Accounting Principles (GAAP). The matching principle requires businesses to align the timing of revenue and the expenses that generate that revenue.
As a practical matter, amortization makes financial statements more comparable from period to period by smoothing large swings that would otherwise be caused by the timing of payments.
How to Record Prepaid Expense Amortization
When a business makes an advance payment, it usually records the prepaid expense during the normal accounts payable process. It receives an invoice or contract, approves and pays it. In this initial step, a business accountant creates the prepaid expense as an asset by adding a debit in that amount to the balance sheet’s prepaid expenses account and reducing cash by crediting the cash account by the same amount. At this stage, only the balance sheet is affected. During this accounts payable process, accountants analyze the details of the transaction to create an amortization schedule that will be followed over the life of the prepaid expense.
In subsequent accounting closes, adjusting entries will be recorded to reduce the prepaid expense (credit) on the balance sheet and recognize the expense (debit) on the income statement. The adjusting entries are made in each accounting period in accordance with the amortization schedule until the prepaid expense asset has been written down to zero and the underlying goods/services have been exhausted. The amount amortized is recorded as a debit to the appropriate general ledger expense account, depending on the type of expense, such as insurance, rent, utilities, taxes, etc.
Prepaid Expense Amortization Example
There are three bookkeeping steps in a classic prepaid expense scenario. To illustrate, consider fictional NKR Partners, a local piano studio offering on-site instruction for young learners. NKR rents a large space in a much-desired location on Main Street. Because it’s such a prime location, the property owner, Lane Realty Associates, requires a two-year rental agreement paid for in advance. In December 2022, NKR signs the rental agreement for 2023-2024 and pays the total amount of $125,000 for the two years.
Step 1 records the advance payment made in December 2022. Since the two-year rental term starts in 2023 it is a prepaid expense on NKR’s balance sheet, rather than a current-period expense. The following journal entry is made in NKR’s general ledger:
Step 2 involves establishing and analyzing the prepaid expense. Since the rental agreement spans two years it is divided between current and long-term assets on NKR’s balance sheet as of Dec. 31, 2022. The amount representing 2023 rent, $60,000, is classified as a current asset. The amount representing the second year’s rent, $65,000, which includes a contracted rent increase for 2024, is classified as a long-term asset. NKR’s bookkeeper creates the following amortization schedule to be followed over the duration of the two-year contract:
Step 3 uses the amortization schedule to systematically reduce the current prepaid rent while moving an equal amount from long term to current as NKR occupies the space during the two-year contract. The following adjusting journal entry is made during every month-end accounting close in 2023, reflecting the rent expense on NKR’s income statement and reducing the prepaid rent down to its unexpired balance.
Streamline Your Close Process With Automated Amortizations in NetSuite
Prepaid expenses are common for businesses of all sizes and industries. But maintaining prepaid expenses and their related amortization schedules becomes tedious and time-consuming when done manually, in spreadsheets. What’s more, in practice, businesses manage dozens or hundreds of prepaid expenses simultaneously, multiplying the tedium and the potential for errors. A software solution such as NetSuite Financial Management can automate the steps involved with amortizing prepaid expenses to help streamline the accounting close. The software can maintain a register for every prepayment, generate the related amortization schedule and automate the adjusting journal entries for the entire life of the prepaid expense asset. This makes a business’s accounting close more efficient and accurate while increasing visibility for internal stakeholders via NetSuite’s drill-down feature.
Prepaid expenses are those paid and recorded before they deliver value to the business. They’re quite common in business, arising from upfront payments for items such as rent, insurance, advertising, subscriptions, software licenses and many others. To be GAAP-compliant, businesses record the prepaid expenses assets and amortize them — or write them down — over time by directly crediting the asset accounts and debiting the related expense accounts over the duration of the period that the prepayment benefits the business. The bookkeeping for this isn’t sophisticated but can become complex, tedious and subject to error if done manually.
Prepaid Expense Amortization FAQs
Why do businesses amortize prepaid expenses?
Prepaid expenses are assets because they represent future economic value. In accordance with the matching principle held by U.S. Generally Accepted Accounting Principles, GAAP-compliant companies must amortize such assets as they are used or consumed. Doing so recognizes the expense on the income statement and reduces the balance of the asset over the time period that the asset benefits the business.
What is an amortization schedule?
An amortization schedule is an outline of how an expense will be paid over time. In the case of prepaid business expenses, companies most commonly calculate amortization using the straight-line method, which evenly apportions costs over the life of the asset. In circumstances where the prepaid expense is not expected to be used at a constant rate, other methods of amortization may be used, such as one based on actual or expected usage.
What other calculations are involved in amortizing prepaid expenses?
When calculating prepaid expense amortization using the straight-line method, the term of the transaction needs to be included along with the value of the prepaid expense. This often includes analyzing the details of the underlying invoice or contract, so as to factor in any other pertinent information, such as cost escalation clauses or usage schedules.
How are prepaid expenses recorded?
Prepaid expenses are initially recorded during the normal accounts payable process, when a properly approved invoice or contract is paid. The prepaid expense is initially created by debiting the asset, and is offset by a credit that reduces cash. This initial step only affects the balance sheet. Subsequent amortization reduces the prepaid expense on the balance sheet and recognizes the expense on the income statement. The balance of the prepaid expense should reflect the unexpired portion of the asset.
What is the accounting entry for amortization of prepaid insurance?
During the accounting close, adjusting accounting entries reduce the prepaid expense via a credit on the balance sheet and increase the appropriate general ledger expense account with an equal debit on the income statement. The adjusting entries follow an amortization schedule until the prepaid expense asset representing the prepaid insurance premium is fully consumed.
What is the journal entry for amortization of prepaid rent?
The journal entry to record amortization of prepaid rent is a debit to the rent expense account and a credit to the prepaid rent asset. The value of the entry is based on the amortization schedule for the period. The journal entry is made as part of the adjusting journal entries step in an accounting close and looks like this:
What is the prepaid expenses journal entry?
The journal entry to initially record a prepaid expense is a debit to the specific prepaid expense asset account and a credit to cash and usually occurs during the normal accounts payable process when an approved invoice or contract is paid. This step only affects the balance sheet and looks like this: