What are prepaid expenses and amortization?

Prepaid expenses are payments you make for goods or services before you receive them. In accrual accounting, you record these payments as current assets on your balance sheet because you have not yet received the full benefit.

For more information, see When is something an expense vs. an asset.

Examples of prepaid expenses

Here are some common examples of prepaid expenses:

• Insurance premiums.
• Rents paid in advance.
• Taxes paid in advance.
• Software subscriptions paid annually.
• Professional services paid in advance, such as advertising, consulting services, or legal services.

What to exclude

Some expenses are often confused with prepaid expenses but should be tracked differently.

• Refundable deposits: These are not prepaid expenses because you do not consume them over time. You usually record these in a separate asset account called “deposits”.
• Deferred tax expenses: These are not payments for future goods or services. They come from temporary differences between book and tax accounting and are recognized as deferred tax assets (DTAs) or deferred tax liabilities (DTLs).

How to amortize prepaid expenses

Prepaid expenses are assets, which are recorded on the balance sheet and then expensed over time through depreciation or amortization. This spreads out the cost to match the benefit received.

As the benefit is consumed, prepaid expenses are amortized/reclassified as expenses. This ensures the expenses are recognized in the same period as the revenues they help generate, which follows the “matching principle” under US generally accepted accounting principles (GAAP).

Amortization methods

You can use different methods to amortize expenses, but your method should align with your business's revenue recognition method.

• Straight line: This is the most common method. You amortize prepaid expenses evenly over specific periods. If you do not receive services on the first day of the period, you recognize expenses on a pro-rated basis. Examples include insurance, rents, and prepaid subscriptions.
• Milestones / project-based: You amortize expenses when you achieve specific performance milestones. For example, in a website design contract, you recognize expenses when specific deliverables like planning or testing are complete.
• Percentage of completion: You amortize expenses by percentage as the work processes, rather than waiting until the work is finished. This is usually for long-term contracts.

Example scenario

In November, your company pays $12,000 for one year of property insurance coverage from January 1st 2025 to December 31st 2025.

1. Initial payment: When you make the payment, you create a journal entry.
   • Debit: Prepaid expenses $12,000
   • Credit: Cash/bank account $12,000
2. Monthly amortization: At the end of each month from January 31st 2025 to December 31st 2025, you amortize the insurance evenly as you consume the coverage.
3. Recurring entry: You create a monthly recurring journal entry.
   • Debit: Property insurance expenses $1,000
   • Credit: Prepaid expenses $1,000

Common mistakes to avoid

• Expensing all prepaid payments immediately.
• Forgetting to amortize, which causes the prepaid amount to stay on the balance sheet forever. Tip: Set up a recurring journal entry to automate the amortization.

Disclaimer: This article is provided for general informational and educational purposes only and is not intended to provide accounting, tax, legal, or financial advice.