Accounting & Bookkeeping & Small Business Forum

[Pearl]

Hi,
Normally, we have to account for, say, prepaid insurance, as per the below:

When prepaid (e.g. for 4 months):

Dr Prepaid Insurance
Cr Cash

When consumed (e.g. first month):

Dr Insurance Expense
Cr Prepaid Insurance

This is the correct accounting treatment.

But, what is the effect if we do the below?

Dr Insurance Expense (the whole amount paid)
Cr Cash

Apart from being incorrect, what's actually the effect? Is is a major problem if we do like that?

Thanks!

[Des]

This conflicts with the matching principle. You should not expense something that hasn't been incurred.

Matching Principle
Quote: The principle that requires a company to match expenses with related revenues in order to report a company's profitability during a specified time interval

For example, you purchase 12 months of insurance on 1/1/08 for $1200.

Correct: 3/31/08 you would have used only $300. In the event you publish quarterly statements (Jan, Feb, March), your expenses would be $300 higher, and assets $300 lower.

Incorrect: 1/01/08 you Expense the full amount of $1200 and credit cash for $1200. Come March when you prepare your quarterly statements you would show Expenses $1200 higher, and assets $1200 lower. This isn't the fact however, because you still have 9 months of insurance coverage.

Of course in the end it has the same effect, but its very important for managers in estimating expenses - also creditors, and investors when analyzing financials. Think about how far off period statements would be for much larger companies like microsoft.

If I didn't explain this clearly let me know.

[Pearl]

Hi Des,

Thank you for your quick response.

In the case of a very small company...

Doing it the wrong way... this will decrease profit, right?

And it will decrease the taxable income, due to the deduction of the full amount, instead of just the expensed part?

How does it affect the estimation of expenses by managers that you've mentioned?

Thank you.

[Des]

For the quarter - Yes expenses will be higher and Income before taxes will be lower, which would represent a lower tax amount. You would also be stating a lower net income than what is actually present.

ie. Statement of Operations - First Quarter

5000 (revenue) - 1200 (expenses) = 3800 (operating income)

vs

5000 - 300 = 4700

But overall it would be the same, because by the end of the year you've expensed the same amount.

Estimating expenses helps Managers plan for the future. Managers can better understand their costs over a period of time and how their assets are being used.

Overall the big point of this is to understand that you would be misrepresenting your business for the last three quarters. Accounting was designed to deliver proper information to external users (investors, creditors, etc) so that they can make proper capital allocations. Recognizing expenses when incurred, is a fundamental of accrual-basis accounting and falls under the matching principle.

[Richard Noot]

[
But overall it would be the same, because by the end of the year you've expensed the same amount.

This would be true only if the prepaid amount was completed in the same year. In most cases this would not be the case. Not only would your books be wrong but your tax return would be wrong also even if you do your taxes on a cash basis.

[Pearl]

Hello,

Thank you both!

That's great that some people take the time to help others in a forum like this.

So, if the statements will not provide a true representation of the financial situation of the business, in a case like this, and the calculation of the tax payable would be wrong, why do you think an external accountant would insist in doing it the wrong way? Can you see any advantage in doing it wrong for him/her??

Thank you.

[Des]

less entrys... maybe to point out growth in the last 3 quarters.. maybe because they are just a bad accountant.

[Pearl]

Thanks for the opinion, David :).

[Danny9394]

If my company is reporting in cash basis

can I expense the $1200 in the first quarter?