Prepaid Expenses and Other Current Assets on the Balance Sheetal explained by professional Forex trading experts the “ForexSQ” FX trading team.
Prepaid Expenses and Other Current Assets on the Balance Sheet
As we continue on the journey to learn how to analyze a balance sheet, I want to turn your attention to a section called prepaid expenses. Simply stated, prepaid expenses on the balance sheet arise as a result of managers and employees conducting ordinary business throughout the year. In the course of everyday operating activities, many firms will end up paying for goods or services before they actually receive delivery of them.
For example, if a jewelry store moved into your local mall, it would most likely have to sign a rental agreement and pay six to twelve months of rent in advance. If the monthly rent was $2,000 and the business prepaid for an entire year, they would put $24,000 on the balance sheet under Prepaid Expenses ($2,000 monthly rent x 12 months = $24,000). Each month, it would deduct 1/12 from the prepaid expenses, transferring it to a cost line on the income statement. By the end of the year, the full $24,000 would have been run through the profits and losses as an expense and there would be $0 in prepaid expense assets shown on the current asset line of the balance sheet.
Types of Expenses Included within “Prepaid Expenses”
There are many types of prepaid expenses including taxes, salaries, utility bills, rents, insurance, or interest expense. These would all be pooled together and put on the balance sheet under this heading.
Prepaid Expenses and Counter-Party Risk
Realize that, to some degree and in some situations, there is a degree of counter-party risk in a prepaid expense. Unless there is some sort of legal requirement that demands the person to whom the bill was paid keep the funds in a segregated escrow account, were the firm or individual to go bankrupt and not be able to deliver the goods or services for which the purchaser had already paid, it could turn into a loss.
At the very least, it would convert the person or firm making the prepayment into a general creditor who had to fight with other creditors for a distribution during a bankruptcy proceeding.
This isn’t so much a concern for giant blue chip businesses, which have experienced management teams and specialists who spend a great deal of time thinking about protecting against such things but could be worth considering if you own a small business or even if you are a consumer. Many years ago in my old hometown, there was a car dealership that had been part of the community for decades. The man who ran it began to engage in some questionable behavior; behavior that made him insolvent without many people knowing. The cars were secured by financing received from the automobile manufacturers. One week, a customer went in and purchased a car or truck for cash. The dealer didn’t hand over the title, but the customer wrote a personal check and agreed to come in sometime in the following week or two to pick up the title and take possession of the vehicle. Unfortunately for this customer, between the time the dealership cashed the check and the time the automobile manufacturers repossessed the inventory on the lot, the title had never been completed.
As a result, this man didn’t actually own the car or truck for which he had paid and became an unsecured creditor in the bankruptcy proceeding.
By their very nature, prepaid expenses are usually a small part of the balance sheet. Under most circumstances, they are relatively unimportant in your balance sheet analysis and shouldn’t be given too much attention unless there is a specific reason you believe they warrant concern.
Notes Receivable on the Balance Sheet
Notes Receivable are debts owed to the company which are payable within one year.
Other Current Assets on the Balance Sheet
Other current assets are non-cash assets that are owed to the company within one year.
Non-Standard Items on the Balance Sheet
Sometimes companies put items on their balance sheet which aren’t standard; perhaps resulting from one-off unique situations that are explained in the 10-K filing.
You have to take these on a case-by-case basis to try and determine the role they play in the overall picture. As you gain more experience analyzing balance sheets, you’ll start to see certain patterns and terms arise from time to time, particularly within a given industry.
To help you with this part, you might want to pick up a copy of Barron’s “Dictionary of Finance and Investing Terms”. The reference book is relatively inexpensive ($10 or $11), and defines over 4,000 financial terms including many of those found on the balance sheet. You may also find the “Dictionary of Business Terms” useful as well. It has 7,500 entries covering almost every business definition you could possibly want to know. While neither is required to do balance sheet analysis, they can save you a lot of time and effort.
Prepaid Expenses and Other Current Assets on the Balance Sheet Conclusion
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