Prepaid expenses may be the most common adjusting journal entry that you’ll make…
and it can be a bit tricky - how come they are an asset when they have the word “expense” in it?
Let’s jump into it!
What are Prepaid Expenses?
Prepaid expenses are expenses that you have purchased…
that have yet to be consumed
Some classic examples can be:
A 12 month software subscription
A ticket to a conference that is taking place in the future
An insurance package that spans multiple periods
How do you calculate Prepaid Expenses?
The formula is rather simple:
Beginning Prepaid Expenses
[+] new amounts paid
[-] benefits incurred
[=] Ending Prepaid Expenses
This is very similar to how many Balance Sheet totals are calculated.
Now let’s cover how you can amortize prepaid expenses…
How do you Amortize Prepaid Expenses?
How to amortize Prepaid Expenses
There are a few ways…
Option 1: Split evenly each month
Many people amortize prepaids by just dividing by an equal amount of parts
So for example...if you buy a 12 month subscription for $12k
Each month you would amortize $1k (12k / 12 months)
This approach is simple & easy to use, but it requires you to have cutoff rules
IE if you make a payment on the 21st of the month, perhaps you start amortizing for the first time next month…
But if you make a payment on the 20th of the month, you’ll start amortizing this month
There’s no official ruling on this, so any cutoff date can work
Option 2: Calculate amortization based off of the days
This is my favorite approach
Because you can use one consistent formula across each prepaid expense…
without having to worry about cut off dates..
Going back to our 12 month example, you would amortize over 365 days
so in January, you would amortize 31 / 365…
and February would amortize 28/365 etc…
You can find an example in this template here
Prepaid expenses are an important part of accrual accounting…
under cash accounting, you’d simple book the full amount as an expense in the month in which it was paid…
causing you to distort the actual consumed services of the business…but simplifying your reporting.