Prepaid Expenses | annotated by Joe

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

Prepaid expenses are expenses that you have purchased...

that have yet to be consumed

Some classic examples can be:

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 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.

What is your preferred way for dealing with Prepaid Expenses?