As your business scales, you’ll likely find yourself entering into new types of contracts that often require annual up-front payment. Here’s why it matters, and how to handle it.
If you’re an earlier-stage company that’s in the process of establishing and refining your accounting operations, this is for you. In the early days, it’s critical to start off right by maintaining clean, accurate, and reliable accounting books. This not only has implications on your internal data dependability but also on your taxes and external auditing down the road (assuming you obtain funding of some type).
In the early days, accounting is typically simple—your business has a low to medium volume of transactions, most of which are recorded as income/expenses in the period they occurred. This won’t work when you get to the point where vendors require your business to sign, for example, a one-year contract with payment due upfront.
Let’s assume your company needs to obtain D&O Insurance (Directors & Officers Insurance, which protects the personal assets of corporate directors and officers in the event they are personally sued for wrongful acts in managing the company). As one can imagine, this type of insurance is not cheap and, depending on the number of directors and officers, can be tens of thousands of dollars a year. Say this insurance costs the company $10,000 for one-year coverage starting April 15, 2021. The insurance company will (likely) require an annual upfront premium (payment) to provide coverage. This will require your company to have a cash outflow of $10,000 in April 2021.
At the end of April, as your accounting team goes through the strokes of closing the books for the month, they may be inclined to record that $10,000 outflow as an expense in April 2021--but that is incorrect. Why? That $10,000 insurance plan covers 12 months, not just one month. Therefore, that $10,000 actually needs to be spread out over the life of the insurance contract (typically called the “service period”). Meaning that as each month passes, a portion of that $10,000 payment will be expensed as opposed to all at once. Here’s what this looks like:
Note: There are certain instances where the IRS allows taxpayers to deduct the full amount of the expense in the period it was paid. For more information on the treatment of prepaid expenses, see the IRS publication here.
While more sophisticated and expensive accounting solutions have the ability to capitalize and amortize these types of prepaid expenses, most accounting software used by small to medium-sized businesses do not offer this feature. This requires accounting teams at these smaller companies to build and manage external prepaid amortization schedules, usually in excel or Google sheets.
This is the exact reason why I built this Prepaid Expense Amortization Model. Not only do I use this model internally to manage our prepaids, but I’ve created a copy for our community to integrate within their accounting operations. In addition to the standard fields such as amount, service period, and general ledger account, you’ll notice I have two checks at the bottom of the schedule. Use this section to reconcile the amounts shown in the model and the amount shown in your ERP. This portion of the model is how I ensure everything tick-and-ties.
Disclaimer: I am not a CPA nor am I providing accounting advice. I studied Finance and Commercial Real Estate, with accounting being foundational in my studies and work experience.