Prepaid expenses journal entry

Introduction

 Sometimes the companies pay for the expenses in advance before the expenses become due. This may be due to some discount being offered or longer subscription or validity being offered. They haven’t been recorded by the company as an expense, but have been paid in advance.

They are initially recorded as assets and as they become due, they are reduced from the expenses balance as per matching concept. They are prepayments made by the company. 

What is Prepaid Expense?

Prepaid expenses are expenses which haven’t been made yet due but paid in advance. They accrue when we pay for something that we will receive in the near future. They don’t provide right at instant time rather in a future course of time. They arise in accrual-based accounting only.

They turn into expenses when we actually use them. As we use, the value of asset usually decreases. The value of asset is then changed with actual expense recognized in the income statement.

The utilization of prepaid expenses happens by charging proportionate amounts to expense accounts. Since these expenses would bring in profits in the future, they are charged against profits of the company.

Steps involved in journal entry of prepaid expenses:

Step 1: Create Advance Payment Invoice

Debit: Prepaid expense

Credit: Liability

(Proforma invoice being received and payment to be made)

Step2: Payments of prepaid expenses

Debit: Liability A/C

Credit: Cash/Bank

(Advance payment being made)

Step 3: Invoiced for expenses

Debit: Expense A/C

Credit: Prepaid Expense A/C

(Expense charge being created and prepaid expense reduced)

Journal Entry of Prepaid Expense:

Prepaid expense is an asset and are increased when debited. Either cash is credited or bank account is credited with prepaid expense. The journal entry required to record the prepaid expense is:

At the time of payment:

ParticularsDrCr
Prepaid Expense A/C Drx,xxx 
      To Cash/ Bank A/C x,xxx

Adjustment entry:

ParticularsDrCr
Expense A/C Drx,xxx 
      To Prepaid Expense A/C  x,xxx

Such expenses are shown on the asset side of balance sheet under Current Assets heading.

Prepaid expense as Current asset:

Current assets are assets that can be readily converted into cash within a year or a working capital cycle.

Current assets include cash, inventory, debtors, prepaid expenses.

Prepaid expenses fulfill the recognition criteria of asset i.e.

  • It is probable that any future benefit associated with the asset will flow to the entity
  • The value of the asset can be measured reliably.

 In the case of prepaid expenses, the above criteria are easily fulfilled. Hence, it is treated as an asset.

Example of prepaid expenses:

Prepaid expenses include the following:

  • Prepaid rent
  • Prepaid supplies
  • Prepaid insurance
  • Prepaid interest
  • Prepaid taxes etc.

Recording prepaid expenses in the financial statements:

Let us understand the procedure of recording prepaid expenses with an illustration:

Hari pays 3 months advance rent for 2021 in the beginning of year Jan 3, 2021 of USD15,000 per month and would clear the remaining bill in due time. How to make entries for this transaction?

Initial entry to recognize the payment of advance rent in cash would be:

ParticularsDrCr
Prepaid rent45,000 
      To Cash/ Bank 45,000

At the time of recognition of rent expense and payment of all rent due at the end of year:

ParticularsDrCr
Rent expenses180,000 
      Cash/ Bank 135,000
      Prepaid Rent 45,000

Presentation in the income statement:

Present expenses are not recorded in the income statement since they are the balance sheet account and effect only balance sheet. Prepaid expenses will allocate to income statement normally at the time of the end of the rental contract.

Total rental expenses amounting to USD180,000 will charge to income statement for the whole year or USD15,000 per month.

Presentation in the balance sheet:

The amount of USD45,000 would be shown in balance sheet under the current assets as follows:

                                                                Extract of asset side of balance sheet

AssetAmount
Current assets             
          Prepaid rent45,000

The similar entries can be passed for prepaid insurance recording as well. Initial entry to recognize the payment of advance insurance payment in cash would be:

ParticularsDrCr
Prepaid insurancexxxx 
      Cash/ Bank xxxx

At the time of recognition of insurance expense and payment of all rent due at the end of year:

ParticularsDrCr
InsuranceXXXX 
      To Cash/ Bank XXXX
       To Prepaid insurance XXXX

Presentation in the income statement:

Rent is charged to debit side of P&L account as insurance is recorded as expense. Prepaid insurance is then deducted from the value of insurance account.

                                               Extract of debit side of Income statement

ParticularsAmount
To insurance A/C XXXX             
 Less: Prepaid insurance XXXXXXXXXX

Presentation in the balance sheet:

The amount of USD45,000 would be shown in balance sheet as follows:

                                                                Extract of asset side of balance sheet

AssetAmount
Current assets
          Prepaid insuranceXXXXX

What is the selling expenses budget? (Definition, Meaning, Example)

Meaning of Selling expense

The expenses that are initiated to achieve the objective of making sales such as sales commission, advertising and promotion, and distribution of merchandise to the customer are selling expenses.

It has to be noted that distribution costs do fall under selling expenses as they are incurred together. Distribution costs include order processing, handling, storage, and other charges.

The senior management shall take responsibility for making and filling the orders by customers. The sales made are appraised at many levels. At the desired target of service, it is appraised finally by customers who matter the most.

However, before the distribution is made, it must go through product checks, territory and distribution outlets, and even salespersons at many points. The sales department shall try to set expenses requirement by desired sales in the year.

What makes up total selling expense?

The components of total operating selling expenses would provide the picture of what the selling expense budget would comprise of. Following are the important selling expenses:

Selling personnel costsThe salesperson is directly involved in selling the product. Hence, the salaries and wages paid to them are included in selling expenses. This shall also include payroll taxes and benefits for the salespeople.
Advertising expenses Selling the product requires placement of products. The placement is done through reaching the customers through various media outlets and advertising platforms be it digital or physical. This requires to make necessary advertising expenses. Most of the time, advertising selling expenses are kept fixed.
Variable selling expensesThese are incurred only when the business makes sales. That means if sales are made, various selling and distribution expenses as ordering costs, handling costs and other selling expenses need to be made and hence, these are variable selling expenses.
Other selling expensesApart from the above major 3 selling expenses, the various selling expenses which are generally fixed in nature include insurance, rent expenses, supplies, travel, and entertainment, etc.

What is the Selling Expense Budget?

The selling expense budget is the framework or plans to estimate the upcoming periods selling expenses. The selling expenses include expenses related to store displays, marketing campaigns, and distribution costs to customers.

The selling expenses is prepared by the senior management in the sales and marketing department to meet the sales goals of the company. If the company expects to increase sales by 20%, the sales and marketing department must estimate the required selling expenses to meet the desired sales goals.

Most of the selling expenses are based on factors such as based on the percentage of sales as salesperson commissions, warranties based on historical returns, advertising expenses based on the discretion of the senior manager. The senior manager tries to justify each expense in the selling expense budget.

The budget is reported and analyzed by the higher officials before making the recommendations and ultimately granting the approval of the budget.

Constructing selling expenses budget

The senior manager should decide on the sales objective of the company first to make an appropriate selling expenses budget. The budget can be further differentiated into quarters detailing out the quarter specific expenses that need to be made.

The senior manager shall estimate the variable costs per unit sold and based on past historical data try to layout the budget. The fixed selling expenses are however based on contractual negotiations which cannot be controlled by the selling and marketing department.

Example

Sinra Inc produces plastic bottles for beverages company. To develop the selling and administrative (S&A) expenses portion of Sinra Inc’s budget, the computation shall start with previous historical data and then with variable expenses that cost about $ 0.20 per unit sold.

The fixed expenses as selling personnel cost about $ 2800 per quarter. The company further estimates that advertising costs for various quarters are $ 200, $ 400, $ 1600 and $ 1000 orderly.

This is based on the previous year’s expenditure. The traveling and entertainment costs come out $ 100, $ 100, $ 200 and $ 400 for all the quarters.

Sinra Inc
Selling Expenses Budget
 Q1Q2Q3Q4Total
Units to Be Sold5,0006,0007,50010,00028,500
Variable Selling expenses per unit0.20.20.20.20.2
Total Variable Expenses$1,000$1,200$1,500$2,000$5,700
Fixed Selling Expenses:     
Selling personnel costs$2,800$2,800$2,800$2,800$11,200
Advertising$200$400$1,600$1,000$3,200
Travelling & entertainment costs$100$100$200$400$800
Total Fixed Expenses$3,100$3,300$4,600$4,200$15,200
Total Selling expense$4,100$4,500$6,100$6,200$20,900

Non-Operating income

Companies conduct various operations while running their business. Some operations are directly aimed at revenue generation while other operations are not related to the company’s main line of operations.

Such operations are called non-operating activities and revenue generated from them is called non-operating income. This can be called as an indirect source of income for companies.

What is non-operating income?

Also known as peripheral or incidental income, this income is derived from sources other than the core operations of the company. It includes dividend income, profit or loss from investment or sale of fixed assets, etc.

The results of non-operating activities are categorized under heads “Other revenue and gains” and “Other expenses and losses”. Non-operating income is popularly called “Other revenue and gains”.

Examples of Non-Operating Income and Gains are given below:

  • Interest received from marketable securities
  • Dividend income from investment
  • Rent received from letting premises
  • Gain on foreign exchange transactions
  • Gain due to discontinued operations
  • Gain from lawsuits
  • Gain due to change in accounting principles

Non-recurring events give rise to non-operating incomes or losses hence, they are reported on a company’s income statement. They are shown separately from normal earnings so that analysts and investors can see how the business performed over a specific period.

Non-operating income is immediately shown after income from operations in the income statement to clear the distinction between these two items.

Presentation of non-operating income in the income statement of the company:

Sinra Inc

Income statement

For the year ended December 31,2020

In the above income statement, we can see that non-operating expenses and non-operating income have been separately shown in the income statement.

  1. Most of the non-operating expenses and incomes are non-recurring.
  2. Non-operating and operating incomes are reported on separate lines in an income statement.
  3. Capital gains from the sale of assets form the part of non-recurring non-operating income

Example:

Assuming after subtracting the cost of goods sold and all of the operating expenses from the sales revenue, a company reported an operating income of $1,500,000 for one year.

In addition to running its core business, the company also made some investments, which brought in $500,000 in dividends and $200,000 in interest income.

During the year, the company paid $600,000 interest for its previous financing year and sold a piece of land at a loss of $100,000 Also, it was sued and was charged for $150,000.

The company’s income from dividend, interest income and interest expenses are all non-operating gains or losses. Overall, the company incurred a net non-operating loss of $150,000 which is shown below.

Dividend Income$500,000
Interest income$200,000
Interest expenses$-600,000
Loss on sale of land$-150,000
Costs of litigation$-100,000
Non-operating income (loss)$(150,000)

Only dividend income and interest income are termed as non-operating income in the above case. We have set off against non-operating gains and expenses as well to get the resultant non-operating loss.

The classification of items as non-operating expense/income depends on the nature of business being carried out. For financial companies, interest income/expenses are treated as operating income/expenses while rest other companies treat it as operating income/expenses.

Non-operating income can be shown in the multi-step income statement:

EBIT is calculated by adding operating income with non-operating income. A positive non-operating income is reported when the total non-operating gains are greater than the non-operating losses. A negative non-operating income (loss) is reported if the non-operating losses exceed the total gains,

Accounting Manipulation

The non-recurring nature of non-operating incomes provides scope for accounting manipulation. Non-operating income may be inflated to compensate for losses on operations. It can also account for incorrect operating income by including gains from unrelated activities.

A sudden increase in profit is more likely to be contributed by unrelated activities and can be non-operating.

Non-operating incomes and expenses are excluded from the calculation of Earnings Per Share (EPS) as not being part of the company’s normal course of operations. Non-recurring events can inflate/deflate the earnings of the company hence, depict the untrue financial position of the company.

Write-offs or write-downs may be considered non-operating expenses if they occur due to one-time sudden events like a natural disaster, the downturn of the economic conditions.

Operating income Vs EBIT

Operating Income

Operating income is the residual amount of revenue left after deduction of the cost of goods sold (COGS) and operating expenses. It is one of the measures of the profitability of the operations of an organization.

It infers investors and owners about the amount of revenue that would eventually turn out to profit for the company.

It is one of the primary indirect indicators of the measure of the efficiency of an entity. Higher the operating income, higher is the operating efficiency and profitability from the core operations.

Operating income can be calculated by the formula:

Operating income = Total Revenue – Direct Costs – Indirect Costs

                                                          Or

Operating income = Gross Profit – Operating Expenses – Depreciation – Amortization                                                   

Earnings before interest and tax (EBIT)

EBIT refers to Earnings Before Interest and Tax. It is calculated by subtracting the cost of goods sold and its operating expenses from sales revenue. EBIT is the sum of net income, interest and taxes. It is a measure of the profitability of the company.

It indicates the earning potential of the company.  It enables us to calculate revenue minus expenses (including interest and tax). EBIT is calculated by the following formula:

EBIT= Net Income + Interest + Taxes

Or,

EBIT = EBITDA – Depreciation and Amortization Expense     

The differences between Operating income and EBIT are as follows:

Basis of differenceOperating IncomeEBIT
DefinitionIt reflects the profits earned by company operationsIt is used to calculate the company’s profitability
UsageIt is used to gauge the profit-making capacity of the company.It is used to know how much revenue can be converted to profits.
GAAPOperating income is the official financial measure by GAAPEBIT is not recognized by GAAP as an official financial measure
Gain or loss from fixed asset saleGain or loss from a fixed asset sale is not included in operating income.EBIT covers gain or loss from sales of fixed assets.
Non-operating expensesNon-operating expenses are excluded in calculating operating income.Non-operating expenses are included in calculating operating income.
Non-operating incomeNon-operating income is excluded in calculating operating income.Non-operating income is included in calculating operating income.
ProfitsIt calculates operating profits only.It calculates profits from other sources too besides operating profit.
AdjustmentsNo adjustments are required in its calculations.Adjustments are made under its calculation.
Operating expensesIt includes operating incomes and expenses only in its calculation.Any other non-operating incomes or expenses are also taken into account
Basis of calculationIt is calculated based on gross income.It is calculated based on net income.
ConsiderationInterest and tax expenses are not taken into account.Interest and tax expenses are added to net income to get EBIT
CalculationGross Income- Operating ExpensesNet Income+ Interest + taxes
Position in the income statementIt is presented above EBIT in the income statement.It is presented below operating income in the income statement.
Performance metricPerformance of business operations can be gauged from operating income vis-à-vis previous year or figure of other firms.Performance of business operations can’t be gauged from operating income vis-à-vis previous year or figure of other firms

The differences between operating income and EBIT can be gauged from the following income statement.

Income statement for the year ended 31st Dec, 2020

Revenue15,00,000
Direct costs5,00,000
Gross Profit10,00,000
Operating expenses 
             Salaries150000
             Repairs50000                                                             2,00,000
Operating Profit                                                                         8,00,000
Interest income                                  50,000
EBITDA                                                                          750,000
Depreciation                                                                             50,000
EBIT                                                                           700,000

From the above income statement, we can easily gauge the difference between operating income and EBIT. In the above statement, we can conclude the following:

  • Operating income is presented above the EBIT.
  • Operating income includes depreciation while EBIT excludes depreciation.
  • Operating income is always higher than EBIT unless otherwise.
  • Operating income includes operating expenses, EBIT includes operating and non-operating expenses.

Operating income

Overview:

Companies operate a business to earn profits. They carry out specific operations to conduct business and generate such profits. Operating incomes are the income generates from principal revenue-generating activities after deducting the operating expense. This residual income is termed as operating income.

It is referred to as the direct source of income for business entities. Operating income could also calculate deducting the cost of goods sold from the net sales of the entity during the specific period.

Operating income

What is operating income?

It is the residual amount of revenue left after deduction of cost of goods sold (COGS) and operating expenses from the total revenue or sales. It is one of the measures of the profitability of the operations of an organization.

It infers investors and owners about the amount of revenue that would eventually turn out to be profits for the company. It is one of the primary indirect indicators of the measure of efficiency of an entity.

Higher the operating income, higher is the operating efficiency and profitability from the core operations.

Operating income can be affected by:

  • Pricing strategy
  • Competition in the market
  • Pricing of the inputs or raw materials and its availability
  • Costs of the direct and indirect labor

The major performance metrics of operating income are EBIT margin and EBITDA margin.

How to compute operating income?

Operating income can be calculated by formula,

Operating income = Revenue- Cost of goods sold – Operating expenses- Depreciation and amortization.

The different ways of calculating operating income are given below:

Operating income can be calculated by the formula:

Operating income = Total Revenue – Direct Costs – Indirect Costs

Or

Operating income = Gross Profit – Operating Expenses – Depreciation – Amortization

Or

Operating income = Net Earnings + Interest Expense + Taxes

It is calculated by the help of figures from the income statement. The income statement is prepared below:

Operating expenses include:

  • Employee and labor expenses
  • Administration overheads
  • Selling and distribution overheads
  • Research and development expenses

It excludes non-operating expenses and non-operating income.

Non-operating expenses include:

  • Interest expenses
  • Loss/gain from disposal of assets
  • Impairment loss

The various components to compute operating income are given below:

Direct costs: They are the expenses which are incurred and attributed to creating or purchasing a product. They are often in the cost of goods sold. They can be variable as well as fixed.

Example of direct costs include:

  • Direct materials- includes raw materials, supplies
  • Direct labor: cost of hiring machine operators, factory workers wages
  • Direct overhead: Power and water consumption: Electricity usage in production

Indirect costs: Operating expenses which are not associated with producing a product or service. Such cost is allocated as overhead costs and charged to various operational activities. Example of indirect costs are:

  • Maintenance and depreciation of factory equipment
  • Rent of factory unit or go down
  • Salary of administration staff etc.
  • Office supplies
  • Printing and stationary
  • Marketing and advertising expenses.
  • Revenue is defined as the monetary amount received after selling goods and services. This can be either cash sales or credit sales. As per AS-9, Revenue is the gross inflow of cash, receivables, or other consideration arising in the course of ordinary activities of an enterprise from the sale of goods and rendering of services and various other sources like rent, royalty, dividend, and interest, etc.
  • Gross income is defined as the amount obtained after deducting the cost of goods sold and sales returns or allowances from the sales figure.

Operating income is calculated in the income statement in the following way:

Operating income

This is how the operating income of a company is calculated.

Percentage change in operating income:

The company needs to know the percentage change in operating income when the comparison is made vis-à-vis in previous years. It shows whether operating income is changing proportionately with sales or cost of sales has been in an increasing trend.

It can be calculated by deducting the operating income of the previous year from the current year and dividing it by the operating income of the previous year.

Use of operating income metric:

Investors, creditors and company uses this metric to gauge efficiency, profitability and overall financial soundness of the company. The higher the operating income the more able a company would be to pay of its debts. This gives investors idea about the future viability of the company concerning its operations.  Operating income can be increased by:

  • Reducing fixed costs
  • Increasing mark-up

Non-operating income

Also known as peripheral or incidental income, this income is derived from sources other than the core operations of the company. It includes dividend income, profit or loss from investment or sale of fixed assets etc.

The results of non-operating activities are categorized under heads “Other revenue and gains” and “Other expenses and losses”. 

Operating vs Non-operating income

The primary difference between operating and non-operating income is that operating income comes from core operations while non-operating income comes from sources other than core operations such as interest from investments or profit from sale of fixed assets.

The other difference would be operating income are consistent and regular phenomena while non-operating income occurs once in a while unless there are investments made by the company from which it receives interest.