A “prepaid asset” is the result of a prepaid expense being recorded on the balance sheet. Prepaid expenses result from one party paying in advance for a service yet to be performed or an asset yet to be delivered. Accounting for prepaid expenditures and ensuring they are properly recognized on your financial statements is a critical piece of financial reporting. In this article, we will delve further into how to appropriately account for prepaid expenses and their impact on the financial statements as well as decision-making. Many purchases a company makes in advance will be categorized under the label of prepaid expense. These prepaid expenses are those a business uses or depletes within a year of purchase, such as insurance, rent, or taxes.

• The value of the prepaid asset is offset by what the cost of the expense would be to each of the affected reporting periods.
• In this way, the asset value of the prepaid expense will be reduced to zero at the end of the time period which was paid for in advance.
• Prepaid expenses are considered a prepaid asset because the item that is paid for in advance, such as the rent or insurance coverage, has monetary value.
• Amortization is a technique of gradually reducing an account balance over time.
• We then divide the $2,000 over the 24 months of the subscription term to arrive at a monthly subscription cost of $83.33, to be recognized on the income statement each month the subscription is utilized.

Would you rather pay $200 each month for one year or prepay $1,500 for the entire year and save $900? The software that’s sold with this type of arrangement is often referred to as SaaS, or “Software as a Service,” because of its similarity to service contracts. Under the matching principles of accrual accounting, revenue and expenses must be recognized in the same period.

Where Do Prepaid Expenses Appear on the Balance Sheet?

When businesses amortize expenses over time, they help tie the cost of using an asset to the revenues that it generates in the same accounting period, in accordance with generally accepted accounting principles (GAAP). For example, a company benefits from the use of a long-term asset over a number of years. Thus, it writes off the expense incrementally over the useful life of that asset. First, amortization is used in the process of paying off debt through regular principal and interest payments over time. An amortization schedule is used to reduce the current balance on a loan—for example, a mortgage or a car loan—through installment payments.

For instance, many companies use spreadsheet-based schedules to manage amortization because their accounting software doesn’t do it for them, but this leaves room for human error. Under pressure to close the books, overworked staff may forget to record a charge one month or enter an expense that has been fully amortized. And because amortized expenses are entered month after month, data entry mistakes are more likely.

Common Reasons for Prepaid Expenses

Prepaid expenses are first recorded in the prepaid asset account on the balance sheet as a current asset (unless the prepaid expense will not be incurred within 12 months). Once expenses incur, the prepaid asset account is reduced, and an entry is made to the expense account on the income statement. For example, if a company pays its landlord $30,000 in December for rent from January through June, the business is able to include the total amount paid in its current assets in December. As each month passes, the prepaid expense account for rent on the balance sheet is decreased by the monthly rent amount, and the rent expense account on the income statement is increased until the total $30,000 is depleted. Regardless of whether it’s insurance, rent, utilities, or any other expense that’s paid in advance, it should be recorded in the appropriate prepaid asset account.

NetSuite has packaged the experience gained from tens of thousands of worldwide deployments over two decades into a set of leading practices that pave a clear path to success and are proven to deliver rapid business value. With NetSuite, you go live in a predictable timeframe — smart, stepped implementations begin with sales do you amortize prepaid expenses and span the entire customer lifecycle, so there’s continuity from sales to services to support. Amortization schedules can be customized based on your loan and your personal circumstances. With more sophisticated amortization calculators you can compare how making accelerated payments can accelerate your amortization.