Balance Sheet Part 5 – Prepaid Expenses is the 5th blog in our Reading Financial Statements Series ©
A prepaid expense is an expense an association has paid in advance. It is an asset of the association. The most common prepaid expense is an association’s annual insurance premium.
What causes a prepaid expense to occur?
Generally, prepaid expenses are recorded when an association has paid for something but has not yet received the benefit of the expenditure.
Example: Prepaid Insurance
Let’s assume your association has a calendar year end (December 31). Your association’s insurance policy period runs from August 1 of the current year (CY) to July 31 of the next year (NY). If your association pays the annual insurance premium of $12,000 in full on July 1, CY, how much will be recorded as an expense and a prepaid expense?
Since the annual premium is $12,000 and there are twelve months in the policy year, the expense for each month is $1,000 ($12,000 divided by 12 months). The expense for the current year will be for the period August 1 to December 31: five months. Five months at $1,000 per month equals $5,000 to be expensed in the current year. What about the other $7,000 of our $12,000 premium? We paid it all in the current year so why can’t we expense it all in the current year? The premiums paid this year that benefit the next year, through the end of the policy period on July 31, will be expensed next year. For this year, we need to account for the $7,000 that benefits next year as prepaid insurance expense and present the account as an asset on the balance sheet.
We ask the next question a lot because it is so important:
What is your accounting basis?
- Cash basis: Revenues recorded when cash is received, expenses recorded when paid.
- Accrual basis: Revenue recorded when earned/billed, expenses recorded when incurred.
Under the cash basis of accounting, the full $12,000 insurance premium would be recorded as an expense when the premium is paid. Using the accrual basis of accounting, the insurance premium is expensed in the current year ($5,000) and in the next year ($7,000) per the analysis above.
Full Accounting and Knowledge
We believe the full accrual basis of accounting provides associations and readers of financial statements with a more complete and accurate representation.