Prepaid Assets

A prepaid asset is a financial resource that a business has paid for in full, although the full benefit of that resource will not be used until a future date.

A prepaid asset can also be expressed as an expense that has been paid for that will not be consumed until a later time.

A prepaid asset is considered an asset because it has economic value to the business. An asset is any resource that has monetary value. A prepaid asset has economic value to the business because of its future benefit.

By eliminating future expenses, a prepaid asset benefits accounting periods in the future. In contrast, a typical expense is recorded in the accounting period when it is incurred. It does not benefit future accounting periods, therefore it has no value and is not considered an asset.

Prepaid assets are similar to deferred expenses. Both involve the fulfillment of a payment obligation in advance of when it is owed, but they are utilized over different spans of time:

• A prepaid asset is consumed in one year or less, so it is considered a current asset

• A deferred expense applies to an expense that is not consumed within one year, so it is considered a long-term asset

Prepaid assets typically refer to administrative expenses, such as rent or leases, advertising, legal retainers, estimated taxes, and other recurring expenses that can be lumped into one prepaid expense. Another common form of prepaid asset is property insurance. A business may pay for six months or a year of coverage in advance to receive a discount on the premium.

When paying for these types of expenses, a business will make one large payment, often a year’s worth of the expense in advance, instead of making regular monthly payments.

In the case of rent, for example, the business will pay a year’s worth of monthly rental payments up front. If the rent for office space is $10,000 per month, the landlord may require the business to make a payment of $120,000 at the beginning of the year.

Prepaid assets are recorded as an asset for the full amount of the payment. The asset will be reduced in subsequent accounting periods in an amount equal to what the monthly payment would have been.

This practice will continue until the asset is completely consumed or depleted.

In the example of the prepaid rent, it will be recorded initially as a $120,000 asset. That value of that asset will be reduced by $10,000 in each monthly accounting period. At the end of twelve months, the asset will be completely depleted.

A prepaid asset will be recorded in its initial journal entry as a debit in the asset account and a credit in the cash account. In each subsequent monthly accounting period, an adjusting journal entry will be made with the value of the monthly payment recorded as debit to the corresponding expense item and as a credit to the prepaid asset.

To visit the office rent example one more time, this prepaid asset would be recorded as an initial journal entry debit of $120,000 in the asset account and a credit of the same amount in the cash account.

Each month, an adjusting journal entry of $10,000 (the equivalent of one month’s rental payment) will be recorded as a debit in the office rent expense account and as a $10,000 credit in the asset account. At the end of twelve months, the office rent expense account will appropriately show a cumulative total of $120,000 in payments for the past year, and the value in the asset account will be depleted to zero.