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:
Particulars
Dr
Cr
Prepaid Expense A/C Dr
x,xxx
To Cash/ Bank A/C
x,xxx
Adjustment entry:
Particulars
Dr
Cr
Expense A/C Dr
x,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:
Particulars
Dr
Cr
Prepaid rent
45,000
To Cash/ Bank
45,000
At the time of recognition of rent expense and payment of all rent due at the end of year:
Particulars
Dr
Cr
Rent expenses
180,000
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
Asset
Amount
Current assets
Prepaid rent
45,000
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:
Particulars
Dr
Cr
Prepaid insurance
xxxx
Cash/ Bank
xxxx
At the time of recognition of insurance expense and payment of all rent due at the end of year:
Particulars
Dr
Cr
Insurance
XXXX
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
Particulars
Amount
To insurance A/C XXXX
Less: Prepaid insurance XXXXX
XXXXX
Presentation in the balance sheet:
The amount of USD45,000 would be shown in balance sheet as follows:
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 costs
The 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 expenses
These 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 expenses
Apart 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.
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.
Most of the non-operating expenses and incomes are non-recurring.
Non-operating and operating incomes are reported on separate lines in an income statement.
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 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
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 difference
Operating Income
EBIT
Definition
It reflects the profits earned by company operations
It is used to calculate the company’s profitability
Usage
It is used to gauge the profit-making capacity of the company.
It is used to know how much revenue can be converted to profits.
GAAP
Operating income is the official financial measure by GAAP
EBIT is not recognized by GAAP as an official financial measure
Gain or loss from fixed asset sale
Gain 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 expenses
Non-operating expenses are excluded in calculating operating income.
Non-operating expenses are included in calculating operating income.
Non-operating income
Non-operating income is excluded in calculating operating income.
Non-operating income is included in calculating operating income.
Profits
It calculates operating profits only.
It calculates profits from other sources too besides operating profit.
Adjustments
No adjustments are required in its calculations.
Adjustments are made under its calculation.
Operating expenses
It includes operating incomes and expenses only in its calculation.
Any other non-operating incomes or expenses are also taken into account
Basis of calculation
It is calculated based on gross income.
It is calculated based on net income.
Consideration
Interest and tax expenses are not taken into account.
Interest and tax expenses are added to net income to get EBIT
Calculation
Gross Income- Operating Expenses
Net Income+ Interest + taxes
Position in the income statement
It is presented above EBIT in the income statement.
It is presented below operating income in the income statement.
Performance metric
Performance 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
Revenue
15,00,000
Direct costs
5,00,000
Gross Profit
10,00,000
Operating expenses
Salaries
150000
Repairs
50000 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.
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
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.
Notes receivables are written promissory notes which give the holder or bearer the right to receive the amount mentioned in the agreement. It is treated as an asset by the holder of the note receivable. Sometimes accounts receivables are converted into notes receivables to allow more time for the debtors to pay the balance.
If the note receivable is due within a year, its treated as a current asset, else treated as non-current assets.
What are the important components of notes receivables?
Important components of notes receivable:
Principal value: The face value of the note mentioned in the note
Maker: The person who makes the note and who promises to pay the holder of the note. He regards this note as notes payable.
Payee: The person who holds the note and who is entitled to receive the payment
Interest: The notes include the rate of interest to be charged on the due amount, the holder has to pay the principal with interest on the due date mentioned in the note itself.
Due date of payment: The notes itself contain the due date of payment and its issue date.
Specimen of notes receivable:
Classification of notes receivable:
Notes receivables should be classified as a current asset if it is due within a year and non-current asset if it is due in more than a year.
If the note has a duration of more than a year and the customer doesn’t pay interest in the first year, unpaid interest should be added to the beginning principal balance in the second year and interest is to be calculated on this new value.
Example:
The maker owes Rs 100,000 to the payee at 12% p.a. and he pays no interest in the first year. The interest earned would be Rs. 12000 for the first year. So, the interest would be calculated on the new principal Rs. 112,000 in the second year. So, the interest would be Rs.13440.
This is how the interest is calculated for notes receivables.
Notes receivable accounting:
Let us take an example and learn accounting for notes receivables.
MPC Co. sells goods to RSP for Rs.60000 with payment due in 30 days. After 60 days of non-payment, notes payable is issued to MPC by RSP Co. for Rs. 60000 at an interest rate of 10% per annum and with a payment of Rs 20000 due at the end of each of the next 90 days.
The accounting entry to record the conversion of accounts receivable to notes receivable is:
Date
Particulars
Debit ($)
Credit ($)
Notes receivable A/C Dr
60000
Accounts receivables A/C
60000
At the end of the month, RSP pays Rs. 20000 along with the interest due amount which is calculated as 60000*10%*30/365= Rs. 494
The entry would be passed as
Date
Particulars
Debit ($)
Credit ($)
Cash A/C Dr
20494
Notes receivables A/C
20000
Interest income A/C
494
At the end of the second month, RSP pays another Rs.20000 as well as interest of 40000*10/100*30/365= Rs. 328.
The entry would be:
Date
Particulars
Debit ($)
Credit ($)
Cash A/C Dr
20328
Notes receivables A/C
20000
Interest income A/C
328
At the end of final month, RSP pays interest of 20000*10/100*30/365= Rs.165 along with the payment of Rs. 20,000.
The entry would be:
Date
Particulars
Debit ($)
Credit ($)
Cash A/C Dr
20165
Notes receivables A/C
20000
Interest income A/C
165
Now the note has been completely discharged, MPC has recorded interest income of Rs. 987
The interest income would be recognized as:
First month
Date
Particulars
Debit ($)
Credit ($)
Interest receivable A/C Dr
494
Interest income
494
Second month
Date
Particulars
Debit ($)
Credit ($)
Interest receivable A/C Dr
328
Interest income
328
Third month
Date
Particulars
Debit ($)
Credit ($)
Interest receivable A/C Dr
165
Interest income
165
When the maturity of the note rises after completion of 90 days, the interest amount is paid to MPC.
This is recorded as:
Date
Particulars
Debit ($)
Credit ($)
Cash A/C Dr
987
Interest receivable
987
Assume if RSP was unable to pay the final installment of R.20000 and the related interest of Rs.165 and MPC has been accruing this interest income, then MPC has to write off the remaining balance of the note with the interest due.
The entry would be passed as:
Date
Particulars
Debit ($)
Credit ($)
Provision for doubtful debts A/C Dr
20165
Interest receivable
165
Notes receivables
20000
Discounting notes receivables:
Notes can be converted to cash by discounting them with the financial institutions. If the maker dishonors the note, the company discounting the note pays to the financial institutions.
When notes are sold with conditions, the company creates contingent liability and it is disclosed in the notes to financial statements.
The discount fee that the bank charges on discounting of notes receivables can be found by:
Discount= Maturity value of note* Discount rate*Discount period