Amortization of prepaid expenses is an accounting process that calculates the incremental or periodic cost of a recurring expense that has been paid for in advance and applies the cost back to each of the individual accounting periods that benefit from the payment.
For example, if a business pays for a year’s worth of insurance coverage, amortization is the process of calculating what the monthly premium would be for the insurance and applying that cost to each of the monthly accounting periods within the year.
A prepaid expense is an expense that is paid for in advance and usually in a lump sum. Items such as insurance and rent can be paid for with one payment that covers the cost of the expense for several months or a year.
Often, businesses prepay expenses in this manner because they can receive a discount.
Prepaid expenses also provide a benefit to a business by relieving the obligation of payment for future accounting periods. In this manner, prepaid expenses are considered an asset.
Anything that has economic value to a business is considered an asset. Prepaid expenses are considered a prepaid asset because the item that is paid for in advance, such as the rent or insurance coverage, has monetary value.
Prepaid expenses are also considered a current asset because they can be easily liquidated—the value can be realized or converted to cash in one year or less.
However, every asset has a cost. The value of the prepaid asset is offset by what the cost of the expense would be to each of the affected reporting periods. For this reason, a business must amortize, or calculate, the monthly cost for a prepaid expense.
In other words, the business must determine what the expense would cost if it were paid for on a monthly basis instead of all at once for the entire year. The process also has the effect of incrementally reducing the total value of the prepaid asset over the duration of its useful life.
To properly amortize a prepaid asset in the most basic calculation, the business will divide the total value of the prepaid expense by the number of months it will last. This is expressed in equation form as: monthly expense = total value/number of months. The calculated or amortized monthly expense is then applied to each reporting period that receives the benefit.
Prepaid expense amortization is used in business accounting in many ways.
Common examples include administrative expenses, such as rent or leases, advertising, legal retainers, estimated taxes, and other recurring expenses that can be lumped into one prepaid expense. Another common form of prepaid asset is property insurance.
A business may pay for six months or a year of coverage in advance to receive a discount on the premium. All of these types of prepaid expenses must be amortized.
Prepaid expenses are recorded in the general ledger as a prepaid asset under current assets.
The full value of the prepaid expense is recorded as a debit to the asset account and as a credit to the cash account.
Each month, as a portion of the amortized prepaid expense is applied, an adjusting journal entry is made as a credit to the asset account and as a debit to the expense account.
In this way, the asset value of the prepaid expense will be reduced to zero at the end of the time period which was paid for in advance.
Similarly, the expense will reach the total of the prepaid amount at the end of that same period.
As an example, if a business prepaid its insurance one year in advance at a cost of $12,000, the expense would be amortized at $1,000 per month.
This would be calculated as $12,000 / 12 months = $1,000/month. The payment would be recorded as a prepaid asset of $12,000.
It would be entered into the general ledger as a debit of $12,000 to the current asset account and a credit for the same amount to the cash account.
Each month, the business’s accounting department would make an adjusting journal entry for the amortized amount of $1,000, representing the amount of one month’s premium payment in the general ledger. It would be entered as a credit in the asset account and as a debit to the insurance expense account.
At the end of twelve months, the asset account would show a balance of zero for the insurance premium and a total of $12,000 in the insurance expense account.
Businesses amortize prepaid expenses according to the matching principal. This states that revenue and related expenses must be recorded in the same accounting period when the transaction occurs, regardless of when money actually changes hands.
For example, if a business pays for a legal retainer for one year of service, the value of that retainer will be amortized over twelve months. The calculated equivalent of a monthly retainer will be recorded as an expense in each of the twelve monthly accounting periods within the year. This will allow the business to apply or match the expense of the legal retainer evenly to each reporting period that is receiving the benefit of the legal services.
The matching principal is applied in accordance with the accrual basis of accounting.
In some instances, a prepaid expense is not applied equally because the benefit is not the same for each accounting period. For example, an insurance policy may offer a different level of coverage at the beginning of the term than it does at the end. In this instance, the amortization would reflect a different cost for the corresponding reporting periods.
An amortization schedule is a schedule that shows the periodic amortized payments for a prepaid expense and the corresponding reduction in value of the asset until its total value reaches zero. For example, an amortization schedule for one year of prepaid insurance would show twelve monthly payments and the corresponding reduction of the total value of the insurance coverage until it reaches zero and a new premium must be paid.