Accounting Treatment of Operating Expenses - Case 3: Prepaid Expense

This is amount of cash paid in excess of the expected one financial period’s expense. The following illustration demonstrates the accounting treatment.

Illustration

Suppose by 31/12/2018, Our Co. ltd had paid salary expenses of $160,000 by check?

Required;

i) Record the transactions in the salary expense account

ii) Extract a P& L account at the end of the year 31/12/2018

iii)Extract a balance sheet as at 31/12/2018

Solution

NB: The learner need to understand that, sometimes the business may decide to pay more money for salary than before it receives the services from the employees. When this happens, it means that the extra cash paid should be excluded from the year’s annual expense for this amount belong to the proceeding period. It is prepaid expense. In this illustration, the business paid extra $40,000 in the month of December. For the sake of clarity the amount is bolded. The accounting treatment is as follows,

Option one: Direct Accounting Approach

Option two: Indirect Approach

Summary

This part has introduced to the entrepreneur/ learner on how to consider end of year adjustments to avoid cases of misrepresentation of accounting information.

This part brought to light the point that in reality, it is not possible to have exact transactions such that income and expenses of a business are up to date hence for one financial period. This part interrogated the issues of both the trading and operating income and expenses of a business and the scenarios that may be in need of adjustments to ensure the entrepreneur prepares financial statements using the relevant information. Therefore, this part four considered end of year adjustments of the following aspects;

Components of trading account and the adjustments thereof. These components are opening and closing inventory, purchases, and sales returns inwards and outwards

Components of profit and loss account which include operating income and operating expenses.

The part four has also introduced the various approaches of end of the year adjustments which include the direct and indirect methods. Under this, it was concluded that in the balance sheet, the accrual and prepayment accounts introduced are treated as current assets and current liabilities respectively. Both the direct and indirect methods are the same in all perspectives for if we use the direct method, we rely on the balances brought down (b/d) in the respective income and expense accounts to infer whether it is a case of current asset or current liability. Similarly, for the indirect approach, we replace the balance brought down (b/d) appearing in the respective income and expense accounts with the respective prepaid, accrual or in advance accounts whose balances brought down (b/d) is the same as indicated in the counterpart income and expense accounts.

Therefore, in this two approaches, the essence is the entrepreneur or learner to either assume the respective income and expense accounts are to be closed down to P&L account with full year charges and the balance brought down (b/d) to represent the current asset or liability or else the amount in shortage or in excess as portrayed by the respective income and expense accounts is represented by the accrued and prepaid accounts which are presented separately from their mother income and expense accounts in that order.