Amortization of Prepaid Expenses

Prepaid expenses are assets that represent payments made for goods or services that have not yet been received or used- like rent, insurance, or supplies. Amortization of prepaid expenses is an accounting process that involves recognizing the expense of an asset that was paid for in advance over the specific period of time during which it is used or consumed. 

Amortization of prepaid expenses helps to ensure that expenses are recognized in the period in which they are used, providing a more accurate picture of a company’s financial performance.

Why Is Amortization of Prepaid Expenses Important?

Amortization of prepaid expenses is important because it ensures that expenses are recognized in the period in which they are used or consumed. Without amortization, a company might overstate its current period profits by failing to recognize expenses that were paid for in advance. 

This could lead to inaccurate financial statements and misleading information for investors, creditors, and other stakeholders. Amortization of prepaid expenses helps to ensure that a company’s financial statements are accurate and in compliance with accounting principles and standards, such as Generally Accepted Accounting Principles (GAAP).

Amortization of Prepaid Expenses Example 

Let’s say the same company pays $18,000 for a 1-year maintenance contract on its office equipment. Here’s how the amortization of the prepaid expense would work in this case:

• Determine the total cost of the prepaid expense and the period of time over which it will be used or consumed. In this case, the total cost is $18,000 and the period of time is 1 year.

• To get the amount of the prepaid expense that should be expensed each period, divide the total cost by the number of periods in which the prepaid expense will be used or consumed. In this case, divide $18,000 by 12 months, which gives a monthly amortization expense of $1,500.

• Record the amount of the prepaid expense that should be expensed each period on the income statement and reduce the balance of the prepaid expense account on the balance sheet by the same amount. Each month, the company would record an expense of $1,500 on the income statement and reduce the balance of the prepaid maintenance account on the balance sheet by the same amount.

After 12 months, the entire $18,000 prepaid maintenance expense would have been fully amortized and expensed on the income statement, with a corresponding reduction in the prepaid maintenance account on the balance sheet.