Operating expense accounts- advanced review
In level two, we concluded that ledger accounts of operating expense nature are business expenses with closing totals. But these items could assume both debit and credit balance brought down at the end of the financial year if there were cases of prepayments or arrears. In such a scenario, they are recorded in the statement of financial position (balance sheet) as current asset and current liabilities in that order. However, there are several challenges that an entrepreneur/learner may face. That is;
One may not know the exact amount of operating expense or income that is for the current financial period due to the mixture of payments belonging to previous period, current and future periods. The following lesson one, substantiates this concern.
Lesson One; Accounting treatment of per annum Operating Expense
In this lesson, we are recapping our discussion on the accounting treatment of operating expense where by the business has paid the exact one year’s amount. In this case, as discussed in level two, the amount recorded on the respective operating expense account is simply posted to the profit and loss account at the end of the financial period. Hence that particular expense account is closed down. In this scenario, there are no cases of either prepaid or accrued expenses that will be recorded in the statement of financial position (balance sheet) at the end of the year. To clarify this aspect, the following illustration will guide you (ie it is a level two extract-name of the firm and period has been modified)
ILLUSTRATION ONE
Assume that Your Co. ltd paid salary of $10,000 per month in cash for twelve months for the year 2019,
Required;
i) Record the transactions in the salary expense account
ii) Extract a profit and loss account for the year ended 31/12/19
iii) Extract a balance sheet as at 31/12/19
Solution
In this illustration one, the total amount is a one year’s expense hence the salary expense account will be closed down to profit and loss account at the end of the financial period with one year’s amount. This is because the $120,000 amount is for one full period. The entrepreneur/learner need to note that in such a case, the missing item technique does not apply for there are no impairment as per as payment timing is concerned.
Lesson Two; Accounting treatment of Accrued Expenses
Sometimes payment of expenses may assume irregular approach such that cash is paid for the past period or in arrears (ie accrued expense). This case is more complicated and reasonable care is necessary in determining the actual per annum amount to be charged in the profit and loss account at the end of the financial period. In level two of this accounting tutorial series, we considered the accounting approach alone to demonstrate how to treat accrued expense. To make it easier for you to understand the concept, an additional tool of a number line will be used to demonstrate the procedure of recording such transactions in the proceeding illustrations whereby both direct and indirect accounting approach will be utilized interchangeably but for every illustration the method adopted will be noted although both approaches have the same accounting interpretation.
NB: That we will post the transactions directly in the respective ledger accounts without journal entries for we already know how to use journals for this purpose. See illustration two for the clarification
ILLUSTRATION TWO
Your co. ltd provided you with accounting information for the year ended 31/12/2019 which portrayed that it had paid rent expense by check of $90,000. Rent per month is $ 10,000.
Required;
i)Record the transactions in the rent expense account
ii)Extract a P& L account at the end of the year 31/12/2019
iii)Extract statement of financial position (ie balance sheet) as at 31/12/2019
Solution
NB1: Remember that the Accrual Concept advocates that expenses should not be only recognized when cash is actually paid but even when it has been incurred. Therefore, as per this accounting concept, we categorize rent expense in to two groups/classes;
One; rent expense actually paid. This is the rent expense amount which represent actual cash outflow from the business in form of checks drawn or cash paid. This are the expenses for the month of January to September as per the above number line.
Two; the unpaid rent expense of the months of October, November and December 2019 as per the number line. This is referred to as accrued rent expense and it does not involve actual cash outflow from the business. It is also known as incurred expense and for this case, it is incurred rent expense.
NB2: According to the accrual concept, both actually paid and incurred expenses are combined or added together to form one period’s (12 months) operating expense, then charged to profit and loss account. This can be done using both direct and indirect approach as shown below
Option one: Direct Approach
NB: That the balance brought down (bal. b/d) on the credit side of the rent expense account represents accrued expense which is treated as a current liability in the statement of financial position.
Option Two: Indirect Accounting Approach
NB: With this approach, an accrued rent expense account is opened for the purposes of posting the accrual amounts to cater for expenses not yet paid at the end of the financial period. In this case, it should be treated as if it had been paid. This is how it goes
Lesson Three; Accounting treatment of Prepaid Expense
In the case of prepaid expense, it entails a scenario whereby the actual cash paid for a particular expense exceeds the one period (12 months) amount as discussed earlier in level two of this accounting tutorial series. To make it easier for you to understand the concept, as it was the case of accrued expense, a number line tool will be used to demonstrate the procedure of recording such transactions in the proceeding illustrations whereby both direct and indirect accounting approach will be utilized interchangeably but for every illustration the method adopted will be noted although both approaches have the same accounting interpretation.
NB: That we will post the transactions directly in the respective ledger accounts without journal entries for we already know how to use journals.
ILLUSTRATION ONE
Suppose by 31/12/2019, Your Co. ltd had paid rent expenses of $32,000. Whereby the business paid $2,000 each month except on 1st December 2019 when it paid a lump sum of $10,000. All expenses were paid by check.
Required;
i) Record the transactions in the rent expense account
ii) Extract a P& L account at the end of the year 31/12/2019
iii)Extract a statement of financial position as at 31/12/2019
Solution
Number line
NB: Remember that the Accrual Concept advocates that expenses should not be recognized when cash is actually paid but even when it has been incurred. However, in this case, it involves actual cash outflow from the business for a period beyond one year that is for sixteen (16) months. That is, out of the $10,000 paid on 1st/12/2019, only $2,000 apply for the year ending 31/12/2019 as shown in the number line, otherwise the rest of $8,000 belong to year of 2020.
Therefore, we can divide the total rent expense paid in to two;
One; rent expense actually paid for the one year’s period which translates to $24,000. This is the exact amount to be closed to profit and loss account at the end of the financial period.
Two; prepaid rent expense of the months of January, February, March and April of 2020 which translates in to $8,000. This amount is not part of 2019 rent expense although it was paid in 2019 and should be knocked out when closing the account to profit and loss account at the end of the financial period. This objective is achieved using both direct and indirect approach as follows;
Option one: Direct Approach
NB: That the balance brought down (bal. b/d) on the debit side of the rent expense account represents prepaid expense which is treated as a current asset in the statement of financial position.
NB: That the balance brought down (bal. b/d) on the debit side of the rent expense account represents prepaid expense which is treated as a current asset in the statement of financial position.
Option Two: Indirect Accounting Approach
NB: With this approach, a prepaid rent expense account is opened for the purposes of posting the prepaid amounts to cater for expenses paid in advance in the month of December. In this case, this amount is should be treated as good as cash in hand for it is not chargeable as an expense of the current financial period.
NB: The use of number line applies to both operating expenses and operating income. In the discussion we have had focused on operating expenses only. But the same approach will apply in the case of accrued income and income in advance cases.
