Prepaid expenses journal entry

Financial Accounting

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:

Adjustment entry:

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:

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

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

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:

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

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

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

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

Financial Accounting

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:

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.

Non-Operating income

Financial Accounting

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.

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.