What is a Prepaid Amortization Schedule?
Prepaid expenses are a common accounting head for all businesses using the accrual basis of accounting. For example, advance payments of rents (one year) or vendor payments (3 months) need to be recorded over the period of use. This recording means that the advance payment will be spread over the time period it is covering.
These bulk payments can occur for all sizes of companies and need to be recorded for the periods they cover and require special accounting techniques that are called prepaid amortization schedules.
There are accounting principles involved, like the realization and the matching principle.
- The realization principle states that income or revenue should only be booked when it is earned.
- The matching principle states that costs and incomes should be booked in the same period to reflect the income's cost better.
To understand how these principles affect the prepaid expenses and their recording in accounting journals, we need to know what prepaid expenses are.
About Prepaid Expenses
Prepaid expenses are the advance payments for something so that the business will be able to use it. For example, Zee Corp. paid advance rentals in January for a year for warehouse usage up to December.
This means that we treat this prepayment as prepaid warehouse rent. Not as a prepaid expense, Zee Corp. will not recognize this prepayment as an expense in January.
Instead, a schedule will be made for January to December, and the rent expense for each month will be reported against the prepaid expense entry at the end of every month.
From the example, the advance payment is booked as a prepaid expense or specifically under the head of prepaid rent. ABC Co will not book it as an actual expense when such prepayments are actually made.
Instead, ABC Co shall keep a schedule and record the total monthly expense to realize as rental expense over the period covered for the rent.
A business’s balance sheet is usually filled with prepaid expenses. These are recorded under Current Assets. The amortization of prepaid expenses is usually reported in the income or profit and loss statement.
About Prepaid Expense Amortization
As we explained above, amortization is the reporting or booking of expenses in the period when the expense was booked. Amortization is usually used for intangible expenses or intangible assets. Tangible assets are depreciated to record their usage and related expenses.
The process of booking an expense at the period in which it is incurred requires adjusting entries which are an essential part of the business’s accounting cycle.
Example of Prepaid Expenses:
Prepaid expenses can be divided into various categories. These can be prepaid insurance, prepaid rent, and any other type of prepaid expense.
Do we Debit or Credit Prepaid Expenses?
Prepaid expenses are expenses a business pays in one accounting period. These expenses will be realized later on in another accounting period.
Prepaid expenses are booked as assets when they are paid. This is done as the prepayment will yield an economic benefit in the future. The expense will be booked when the prepayment is reversed and reduced at the time of amortization.
This is done in light of the matching principle in accounting.
Similarly, a prepaid income is a revenue received by a buyer in advance, but it is not yet earned. Since income should be booked at the time it is earned, so prepaid income is not booked as income on the date or period it is paid but in the actual period in which the service paid for is offered and payment is earned.
The common entry for recording prepaid expenses regardless of the head is as follows:
Prepaid Expense Dr.
Cash or bank Cr.
This entry records the prepayment and the reduction of cash or bank balance.
Now after every period passes, the following amortization entries are recorded:
Amortization Expense- Expense head Dr
Prepaid Rent Cr.
Please note that the amortization amount in this entry will be for the month or quarter and not the entire amount that has been prepaid.
These entries will be recorded after each period ends, and over a year, the different credits will reduce the prepaid expense balance to zero.
The entries that book realized expenses against prepaid expenses are known as adjusting entries.
These entries do not show new transactions but are made to adjust earlier transactions according to changing scenarios. It is necessary that adjusting entries are booked against prepaid expenses.
These serve to recognize expenses in the period in which they are booked (realization principle of accounting).
The Prepaid Amortization Schedule
Because of the way we do business and how some transactions are conducted, prepaid expenses will always be there.
For instance, insurance or advertising or rent is a prepaid expense since the objective of prepaying these expenses is to get better rates, higher ratings and simply how business is done.
Now, imagine that you are an accountant for a business and are maintaining manual accounts. Since there are multiple accounts that are prepaid and need amortizing over a year, it is easy to lose track of an account.
To manage prepayments and their entries properly, accountants and bookkeepers make an amortization schedule and use it to keep track of their prepaid accounts and their related entries.
The graph at the bottom indicates how the amortization schedule reduces over the year to reach a zero balance as all periods record their allied expenses, and the prepaid balance reduces to zero.
This is similar to a depreciation schedule, except that amortization is usually for a short period of up to a year, while a depreciation schedule is for the life of an asset.
To conclude, accounting for prepaid expenses is very important. It is also very important to realize expenses in the period in which they are booked.
The prepaid amortization schedule is very useful in helping accounts staff maintain a track record of how and when to book amortization entries and realize expenses as and when they are incurred.
It is also used according to the concept of the matching principle where the expenses have to be recognized in the period it is incurred in order to book revenue.