Accounting for Prepaid Maintenance Contracts
Businesses contract with outside companies to provide a variety of maintenance tasks on a regular basis. These outside companies include cleaning services, plant care and garbage disposal. These activities fall outside the primary operation of the business. Contracting these responsibilities allows the company to focus on its business operation.
Companies enter into prepaid maintenance contracts for several months at a time. The company pays the full amount of the contract up front and the maintenance company promises to provide the service for the duration of the contract. When the company enters the contract, the company records the contract as a prepaid asset in the accounting records. The accountant records this by debiting "Prepaid Maintenance Contract" and crediting "Cash" for the amount paid for the contract.
At the end of each period, a portion of the contract expires. During the period, the contractor provides maintenance services to the business. Since the full payment was already made, no further payments are required. However, the expiration of the contract portion must be recorded. The accountant determines the amount of the contract that expired by taking the full payment for the contract and dividing it by the number periods covered by the contract. The accountant debits "Maintenance Expense" and credits "Prepaid Maintenance Contract" for the dollar amount of the expired portion of the contract.
Prepaid maintenance contracts are current asset accounts. A current asset will be used within one year. A prepaid maintenance contract rarely extends beyond one year and qualifies as a current asset. The balance sheet divides assets into current assets and noncurrent assets. The balance sheet lists current assets first.
The income statement communicates profitability of the company by subtracting expenses from revenues to determine net income. The accountant includes all of the operating expenses. The expired portion of the maintenance contract, or "Maintenance Expense," gets reported on the income statement to arrive at the company’s net income.