Expense Amortization: Streamlining Your Close Process (2024)

Anyone who has rented an apartment or paid for car insurance should be familiar with theconcept of prepaid expenses — paying upfront for goods or services they will receivelater, over time. Businesses do this all the time. But unlike individuals, businesses mustfollow accounting rules that complicate the transaction beyond simply writing a check orinitiating a digital payment. Why? Because that prepayment is an asset that has value beyondthe present time.

As a result, businesses that follow the accrual method of accounting use amortization as away to spread prepaid expenses over the accounting periods in which the business will derivevalue from them. And since accrual accounting is the basis for financial statements that alender, regulator or potential partner would likely require, it’s important tounderstand prepaid expenses and the related amortization. It’s not complex, but it canbe 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 servicebefore 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-basisaccounting: Simply record the entire amount as an expense when the cash is paid. Butthat can be hard on the business’sincome statement, since the entire — often large — expense hits all inone period, potentially causing confusing swings in profitability. Accrual basis accountingrequires a different approach. In this method, the prepayment is capitalized as an asset andthen amortized. This treatment is a bit more complicated but does a better job of reflectingthe expense in the periods the expense will cover.

Key Takeaways

• A prepaid expense is an asset arising from when a business pays for a product or servicein advance of receiving it, such as upfront payments for rent, insurance, software andmany others.
• Amortizing the prepaid expense matches expenses to the right period in accordance withGenerally Accepted Accounting Principles (GAAP).
• Each prepaid expense is unique based on its underlying transaction and requires analysisto create an appropriate amortization schedule.
• The right accounting software can maintain a prepayment register, generate the relatedamortization schedules and automate the adjusting journal entries, making the accountingclose more efficient and less susceptible to error.

Prepaid Expense Amortization Explained

Prepaid expenses represent future economic value, which is why they are initially recorded asan asset on a company’s balance sheet. As theasset is used, the amount consumed is recognized as an expense on the income statement byusing a convention called amortization. (Together, the balance sheet, income statement andcash flow statement are the three most important financialstatements for small businesses.) Amortization is the systematic “writingdown” of an asset during the time period when the asset benefits the business. Overtime, the prepaid expense asset becomes smaller and the accumulated amount of the recognizedexpense 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 areamortized using the straight-line method, which evenly spreads the expense over the periodof benefit. For example, an amortization schedule for a six-month insurance premium wouldshow one-sixth of the premium being transferred to insurance expense each month for sixmonths. Sometimes it may be more accurate to use a different method of amortizationdepending on the nature of the prepaid expense. For example, it may be more appropriate toalign the amortization of prepaid advertising costs with the months the campaign is expectedto run, even though the advertising might deliver benefits to the business long after thecampaign is complete.

Types of Prepaid Expenses

Businesses prepay many types of expenses. In all cases, the prepaid expense represents anasset to the company because it has future economic value. However, how that asset isclassified on the balance sheet and the method used to amortize it vary depending on theduration for which value is received and the nature of the transaction. Prepaid expensesthat are expected to be used up within one fiscal year are reflected as current assets on abalance sheet, affecting workingcapital. 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 usedwithin one year is classified as a current asset and the remainder that extends beyond oneyear 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 atthe beginning of a rental agreement. For the renting business, this advance payment is aprepaid expense because it has not yet occupied the space for the entire time covered bythe payment. For example, an annual rental agreement may be paid in a single installmentin 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 coverageperiods, paid in advance. When the payment is made, the premium represents a prepaidexpense for the policyholder because they have not yet received the insurance coveragefor the entire period. A prepaid insurance asset is valued as the prorated portion ofthe unexpired insurance premium.

• Advertising:

  The cash a business pays for an advertising campaign that has yetto begin or is still running is considered a prepaid expense for the advertiser andreflected as an asset on its balance sheet. Prepayment is commonly required in order toreserve advertising space. But the expense should be recognized when the ads run, notwhen they are paid. A prepaid advertising expense would be reflected as an asset on thebalance sheet until that time.

• Other:

  Prepayments are common in business and there are many other types. Thedetails of each situation are unique, but the accounting follows the same three-steppattern: Make an advance payment, establish an asset for the prepaid expense andamortize it over the period of consumption. Some examples of other prepaid expenses aresubscriptions, professional services fees, supplies, software licenses, maintenancecontracts, taxes and utilities.

Because it’s impossible to include a comprehensive list of every possible prepaidexpense scenario, it’s more useful to understand the concept in order to identifytransactions 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’sfinancial statements more accurate. Amortization is the method for apportioning paymentsover the fiscal periods in which they have an impact, a requirement for compliance withaccounting’s matching principle, which is one of the key tenets of U.S.Generally Accepted Accounting Principles (GAAP). The matching principle requiresbusinesses 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 toperiod 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 thenormal 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 byadding a debit in that amount to the balance sheet’s prepaid expenses account andreducing cash by crediting the cash account by the same amount. At this stage, only thebalance sheet is affected. During this accounts payable process, accountants analyze thedetails of the transaction to create an amortization schedule that will be followed over thelife of the prepaid expense.

In subsequent accounting closes, adjusting entries will be recorded to reduce the prepaidexpense (credit) on the balance sheet and recognize the expense (debit) on the incomestatement. The adjusting entries are made in each accounting period in accordance with theamortization schedule until the prepaid expense asset has been written down to zero and theunderlying goods/services have been exhausted. The amount amortized is recorded as a debitto the appropriate general ledger expense account, depending on the type of expense, such asinsurance, 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 younglearners. NKR rents a large space in a much-desired location on Main Street. Becauseit’s such a prime location, the property owner, Lane Realty Associates, requires atwo-year rental agreement paid for in advance. In December 2022, NKR signs the rentalagreement for 2023-2024 and pays the total amount of $125,000 for the two years.

Step 1 records the advance payment made in December2022. Since thetwo-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’sgeneral ledger:

Step 2 involves establishing and analyzing the prepaidexpense.Since the rental agreement spans two years it is divided between current and long-termassets 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’srent, $65,000, which includes a contracted rent increase for 2024, is classified as along-term asset. NKR’s bookkeeper creates the following amortization schedule to befollowed over the duration of the two-year contract:

Step 3 uses the amortization schedule tosystematically reducethecurrentprepaid rent while moving an equal amount from long term to current asNKR occupies the space during the two-year contract. The following adjusting journal entryis made during every month-end accounting close in 2023, reflecting the rent expense onNKR’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 maintainingprepaid expenses and their related amortization schedules becomes tedious and time-consumingwhen done manually, in spreadsheets. What’s more, in practice, businesses managedozens or hundreds of prepaid expenses simultaneously, multiplying the tedium and thepotential for errors. A software solution such as NetSuite Financial Managementcan automate the steps involved with amortizing prepaid expenses to help streamline theaccounting close. The software can maintain a register for every prepayment, generate therelated amortization schedule and automate the adjusting journal entries for the entire lifeof the prepaid expense asset. This makes a business’s accounting close more efficientand accurate while increasing visibility for internal stakeholders via NetSuite’sdrill-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 asrent, insurance, advertising, subscriptions, software licenses and many others. To beGAAP-compliant, businesses record the prepaid expenses assets and amortize them — orwrite them down — over time by directly crediting the asset accounts and debiting therelated expense accounts over the duration of the period that the prepayment benefits thebusiness. The bookkeeping for this isn’t sophisticated but can become complex, tediousand 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 withthe matching principle held by U.S. Generally Accepted Accounting Principles, GAAP-compliantcompanies must amortize such assets as they are used or consumed. Doing so recognizes theexpense on the income statement and reduces the balance of the asset over the time periodthat 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 caseof prepaid business expenses, companies most commonly calculate amortization using thestraight-line method, which evenly apportions costs over the life of the asset. Incirc*mstances where the prepaid expense is not expected to be used at a constant rate, othermethods of amortization may be used, such as one based on actual or expected usage.

What other calculations are involved in amortizing prepaidexpenses?

When calculating prepaid expense amortization using the straight-line method, the term of thetransaction needs to be included along with the value of the prepaid expense. This oftenincludes analyzing the details of the underlying invoice or contract, so as to factor in anyother 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 aproperly approved invoice or contract is paid. The prepaid expense is initially created bydebiting the asset, and is offset by a credit that reduces cash. This initial step onlyaffects the balance sheet. Subsequent amortization reduces the prepaid expense on thebalance sheet and recognizes the expense on the income statement. The balance of the prepaidexpense should reflect the unexpired portion of the asset.

What is the accounting entry for amortization of prepaidinsurance?

During the accounting close, adjusting accounting entries reduce the prepaid expense via acredit on the balance sheet and increase the appropriate general ledger expense account withan equal debit on the income statement. The adjusting entries follow an amortizationschedule until the prepaid expense asset representing the prepaid insurance premium is fullyconsumed.

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 expenseaccount and a credit to the prepaid rent asset. The value of the entry is based on theamortization schedule for the period. The journal entry is made as part of the adjustingjournal 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 prepaidexpense asset account and a credit to cash and usually occurs during the normal accountspayable process when an approved invoice or contract is paid. This step only affects thebalance sheet and looks like this: