Similarly, someone asked Are loose tools current assets
Similarly, someone asked Are loose tools current assets
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Definition Prepaid expenses are those expenses whose payments are done in advance which can be for the goods or services whose benefit will accrue in the subsequent accounting period. A prepaid expense is a current asset. prepaid expenses are classified under the head current assets in the balance sRead more
Definition
Prepaid expenses are those expenses whose payments are done in advance which can be for the goods or services whose benefit will accrue in the subsequent accounting period.
A prepaid expense is a current asset. prepaid expenses are classified under the head current assets in the balance sheet.
This is because they provide future economic benefits to the company. As such, they are assets that can be used to generate revenue in the future.
For example prepaid rent, prepaid insurance, etc.
Current assets are defined as cash and other assets that are expected to be converted into cash or consumed in the production of goods or rendering of services in the normal course of business.
Or in other words, we can say that the expected realization period is less than the operating cycle period although it is more than the period of 12 months from the date of the balance sheet.
For example, goods are purchased with the purpose to resell and earn a profit, debtors exist to convert them into cash i.e., receive the amount from them, bills receivable exist again for receiving cash against it, etc.
Current liabilities are liabilities that are payable generally within 12 months from the end of the accounting period or in other words which fall due for payment in a relatively short period.
For example bills payable, short-term loans, etc.
Why current assets and not a current liability?
Now let me try to explain to you that prepaid expenses are classified as current assets and not as a current liability which is as follows :
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- we can say that the expected realization period is less than the operating cycle period although it is more than the period of 12 months from the date of the balance sheet.
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- expected to be converted into cash or consumed in the production of goods or rendering of services in the normal course of business.
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- In the business prepaid expense are treated as an asset which we can see on the asset side of the balance sheet.
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- Or in other words, we can say that it is initially recorded as a prepaid expense as an asset in the balance sheet and subsequently its value is expensed over time in the profit and loss account.
Example
Now let us take an example for explaining prepaid expenses which are mentioned below.
An insurance premium of Rs 50000 has been paid for one year beginning (previous year). The financial year ends on 31st march YYYY.
It means the premium for 6 months i.e., 1st April, YYYY(current year) to 30th September, YYYY(current year) amounting to Rs 25000 is paid in advance.
Thus, of premium paid in advance (Rs 25000) is a Prepaid Expense. It will be accounted as an expense in the financial year ending 31st march next year. In the balance sheet as of 31st march YYYY ( current year ) it will be shown as Current Asset.
Here is an extract of the profit /loss account and balance sheet of the above example:
Key points
There are a few things to keep in mind when dealing with prepaid expenses.
- First, is that the expenses are actually prepaid. This means that the expenses were paid for before they were used.
- Second, it is essential to track the number of prepaid expenses that have been used. That is to make sure that the prepaid expenses are not overstated on the company’s financial statements. This can happen if the company pays for more goods or services than it actually
- Last but not least it is important to keep in mind that changes in the value of prepaid expenses can impact the company’s net income. For example, if the company’s prepaid insurance increases in value, this will increase the company’s net income.
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Accruals are not the same as provisions both are totally different from each other. Accruals and provision both are vital parts of accounts but work differently Accrual Accrual expense means the transaction that takes place in a particular period must be accounted for in that period only irreRead more
Accruals are not the same as provisions both are totally different from each other. Accruals and provision both are vital parts of accounts but work differently
Accrual
Accrual expense means the transaction that takes place in a particular period must be accounted for in that period only irrespective of the fact when such an amount has been paid.
An accrual of the expenditure which is not paid will be listed in the books of accounts. These accruals can be further divided into two parts
Accrual Expense
Accrual Expense means any transaction that takes place in a particular period but the amount for it will be paid on a later period.
For example- 10,000 for the month of March was paid in April month then this rent will be accounted for in the books in March
These are the following accrued expense
- Accrual Rent– Accrual rent means the amount for using the land of the landlord is paid at a later period than the period when it is put into use.
- Insurance– Accrual insurance means the amount paid as a premium to the insurance company paid on a later period than the period when it is due
- Expense- Acrrual expense means the amount for any expense paid on a later period then the period when it pertains to be paid
- Wages- Accrual wages means the amount which is paid to employees on a later period than the period when the wages get due
Accrual Revenue
Accrual Revenue means any transaction that takes place in a particular period but the amount for it will be received on later period. For example- If interest of 10,000 on bonds for the period of March is received in April months then this amount will be accounted for in March. These are the following accrued revenue
- Accrual Rent– Accrual rent means the amount for using the land of an entity by another party is received on a later period than the period when it was put into use.
- Accrued Interest– Accrued interest means the amount of interest received on a later period than the period when it pertains to receive
PROVISIONS
Provision refers to making a provision/allowance against any probable future expense that the company might incur in the near future. This amount is uncertain and difficult to predict its surety.
However, as per the prudence concept of accounting a company needs to anticipate the losses that will incur in the near future due to which provision is made.
For example- A company has debtors of 10,000 but as per the company’s previous records company anticipates that 1% of debtors will become bad debts. So in this case company will make a provision of 1% that is 100 on it.
There are various types of provisions which are-
- Provision on Depreciation– Provision for Depreciation means a provision for future depletion of assets has been already created
- Provision for Doubtful Debts– Provision for Doubtful Debts means a provision created against debtors that doesn’t seem to be recovered in the near future
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The profits earned by a company are mainly divided into two parts: Dividend, and Retained Earnings The part of profit distributed to its shareholders is called a dividend. The part of the profit that the company holds for future expansion or diversification plans is called retained earnings. As theRead more
The profits earned by a company are mainly divided into two parts:
- Dividend, and
- Retained Earnings
The part of profit distributed to its shareholders is called a dividend. The part of the profit that the company holds for future expansion or diversification plans is called retained earnings.
As the name suggests, retained earnings are the profit that is retained in the company. Retained earnings can be used for various purposes:
- To distribute as dividends to shareholders
- Expansion of business
- Diversification
- For an expected merger or acquisition
As the profits of the company belong to shareholders, retained earnings are considered as profits re-invested in the company by the shareholders.
The formula to calculate the cost of retained earnings is:
(Expected dividend per share / Net proceeds) + growth rate
- Expected dividend is the dividend an investor expects for his investment in the company’s shares based on the last year’s dividend, trends in the markets, and financial statements presented by the company.
- Net proceeds is the market value of a share, that is, how much an investor would get if he sells his shares today.
- Growth rate represents growth of company’s revenue, dividend from previous years in the form of a percentage.
The expected dividend per share is divided by net proceeds or the current selling price of the share, to find out the market value of retained earnings.
The growth rate is then added to the formula. It’s the rate at which the dividend grows in the company.
For example:
The net proceeds from share is Rs 100, expected dividend growth rate is 2% and expected dividend is 5.
Cost of retained earnings
= (Expected dividend per share / Net proceeds) + Growth rate
= (5 / 100) + 0.02
= 0.07 or 7%
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Bad debts mean the money owed by customers who have gone bankrupt or the likelihood of who's ever returning the money is significantly low. Bad debt is a nominal account. A nominal account is an account that records the business transactions belonging to a certain category of income, expense, profitRead more
Bad debts mean the money owed by customers who have gone bankrupt or the likelihood of who’s ever returning the money is significantly low. Bad debt is a nominal account.
A nominal account is an account that records the business transactions belonging to a certain category of income, expense, profit or loss. The balances on nominal accounts are normally written off at the end of each financial year. For example, sales A/c, purchases A/c, interest income, loss from the sale of assets etc.
Why are bad debts A/c classified as a nominal account?
First of all, let us understand the other two types of accounts – personal accounts and real accounts.
Personal accounts deal with the records of the business’ transactions with a particular person or entity. For example Mukesh A/c, Mahesh A/c, Reliance A/c, Suresh and Co. A/c etc.
Real accounts deal with transactions and records related to assets. The balance in these accounts is normally carried forward from one period to another. For example “Furniture A/c “, ” Building A/c ” etc.
Now that we have understood the basic definitions of all three types of accounts, we can discuss the reason behind the classification of bad debts as nominal accounts.
A bad debt is a loss that the company has incurred. It may be due to bankruptcy of customers, customer fraud etc. The company isn’t going to receive that money. The bad debts are written off at the end of the year by transferring them to profit and loss A/c.
Thus, bad debts relate to loss and are normally not carried forward from one period to another. Hence, they are classified as nominal accounts.
Treatment of Bad Debts
Bad debts are written off at the end of each year by debiting them to the profit and loss A/c. The amount of bad debts is reduced from the amount of debtors that the company has.
A company may also choose to create a provision for bad debts for the balance amount of debtors that the company has after adjusting for bad debts. This provision represents a rough estimate of the amount due to debtors that the business expects to not receive. In other words, it is an estimate of customer bankruptcy that the business expects.
Conclusion
We can conclude that
- There are primarily three types of accounts – real, personal and nominal.
- Bad debts are a nominal account.
- Bad debts is a loss that the business has incurred
- It may be due to bankruptcy of customers, fraud etc
- Bad debts are written off each year by transferring them to the income statement
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Return inwards are the goods returned by the customer to the seller. The goods are returned for reasons like defects, excess delivery, and low quality. Return inwards are also known as Sales Returns. Sales returns are a contra account to sales revenue. The amount of sales returns is deducted from thRead more
Return inwards are the goods returned by the customer to the seller. The goods are returned for reasons like defects, excess delivery, and low quality. Return inwards are also known as Sales Returns.
Sales returns are a contra account to sales revenue. The amount of sales returns is deducted from the total sales in the Trading section of the Trading and Profit & Loss Account.
In subsidiary books, return inwards are recorded only for those goods which are sold on credit to the customer.
For example, On 1 August E Electronics sold 50 units of television to Hill Hotels on credit for Rs.25,000 each. Out of which 5 units were found to be defective and were returned back to E Electronics. In that accounting period, E Electronics made a total sales of Rs.20,00,000 (including the item sold to Hill Hotels).
E Electronics in its Trading section of Trading and P&L A/c will account for a sales return of Rs.1,25,000 (Rs.25,000*5) and this amount will be deducted from the total sales. The same will be recorded in the subsidiary books as it accounts for sales made on credit.
Extract of Profit & Loss Account:
For a business, sales returns will either have a decrease in the sales revenue or it will increase the sales returns and allowances which is a contra account to sales revenue. An increase in sales returns will decrease gross profit.
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In a partnership firm, the partners may withdraw certain amounts from the firm for their personal use. Such amounts withdrawn by the partners are called drawings. This amount is usually deducted from their capital. The partners are required to pay an amount as interest, based on the time period forRead more
In a partnership firm, the partners may withdraw certain amounts from the firm for their personal use. Such amounts withdrawn by the partners are called drawings. This amount is usually deducted from their capital. The partners are required to pay an amount as interest, based on the time period for which the money was withdrawn. This amount is called Interest on Drawings.
The journal entry for interest on drawings is as follows:
Since interest on drawings is an income to the firm, it is credited based on the rule that “increase in incomes are credited”. Since the partner has to bear the interest amount, his capital account is debited as a “ decrease in capital is debited”.
FORMULAS
The basic formula for interest on drawings is:
Interest on drawings = Amount of Drawings x Rate/100 x No. of months/12- When equal amounts of drawings are withdrawn at the beginning of every month, then
Interest on Drawings = Total Drawings x Rate/100 x (12+1)/2 - When equal amounts of drawings are withdrawn at the end of every month, then the Interest on Drawings = Total Drawings x Rate/100 x (12-1)/2
- When the date of the drawing is not specified, it is assumed to be withdrawn evenly. Hence Interest on Drawings = Total Drawings x Rate/100 x 6/12
The calculations in 1,2 and 3 are done so that drawings can be calculated for the average period.
EXAMPLE
Jack is a partner who withdrew $20,000 on 1st April 2020. Interest on drawings is charged at 10% per annum. If we have to calculate interest on drawings as of 31st December, then
Interest on Drawings = 20,000 x 10/100 x 9/12 = $1,500
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(Here, interest on drawings is outstanding for 9 months, that is from April to December) - When equal amounts of drawings are withdrawn at the beginning of every month, then
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Accrual Accrual expense means the transaction that takes place in a particular period must be accounted for in that period only irrespective of the fact when such amount has been paid. An accrual of the expenditure which is not paid will be listed in the books of accounts. These accruals can be furtRead more
Accrual
Accrual expense means the transaction that takes place in a particular period must be accounted for in that period only irrespective of the fact when such amount has been paid.
An accrual of the expenditure which is not paid will be listed in the books of accounts. These accruals can be further divided into two parts
Accrual Expense-
Accrual Expense means any transaction that takes place in a particular period but the amount for it will be paid on a later period.
For example- If rent of 10,000 for the month of March was paid in April month then this rent will be accounted for in the books in March
For example- Interest of 1,000 for the month of March of the loan amount of 10,000 paid in April then will be accounted for in the books in March
These are the following accrued expense
- Accrual Rent– Accrual rent means the amount for using the land of the landlord is paid at a later period than the period when it is put into use.
- Accrual Insurance– Accrual insurance means the amount paid as a premium to the insurance company paid on a later period than the period when it is due
- Accrual Expense- Acrrual expense means the amount for any expense paid on a later period than the period when it pertains to be paid
- Accrual Wages- Accrual wages means the amount which is paid to employees on a later period than the period when the wages get due
- Accrual Loan Interest– Loan Interest means the amount of interest on a loan which is paid on a later period than the period when it is due on
Accrual Revenue-
Accrual Revenue means any transaction that takes place in a particular period but the amount for it will be received in the later period.
For example- If interest of 10,000 on bonds for the period of March is received in April months then this amount will be accounted for in March. These are the following accrued revenue
For example- Rent of 10,000 for the month of March received in April month then this rent will be accounted for in the books in March
- Accrual Income- Acrrual expense means the amount for any income received on a later period than the period when it pertains to be received
- Accrual Rent– Accrual rent means the amount for using the land of the entity by the other party is received at a later period than the period when it is put into use.
- Accrued Interest– Accrued interest means the amount of interest received on a later period than the period when it pertains to receive
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External liabilities are the amounts which a business is obliged to pay to the outsiders (who are not owners of the business). Here is the list of external liabilities:- Accounts payable ( trade creditors and bills payables) Loan taken from outsiders Loan from bank Debentures Public deposits accepteRead more
External liabilities are the amounts which a business is obliged to pay to the outsiders (who are not owners of the business).
Here is the list of external liabilities:-
- Accounts payable ( trade creditors and bills payables)
- Loan taken from outsiders
- Loan from bank
- Debentures
- Public deposits accepted
- Outstanding expenses
- Outstanding salary
- Outstanding rent
- Outstanding tax
- Interest due on loans taken from outsiders
The list is not exhaustive.
Just for more understanding, internal liabilities are those liabilities which a business is supposed to pay back to its owners. Such as capital balance, profit surplus etc.
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All expenses whose benefits are received over the years or the expenses or losses that are to be written off over the years are classified as Deferred revenue expenses. It includes fictitious expenses like preliminary expenses, loss on issue of debentures, advertising expenses, loss due to unusual oRead more
All expenses whose benefits are received over the years or the expenses or losses that are to be written off over the years are classified as Deferred revenue expenses. It includes fictitious expenses like preliminary expenses, loss on issue of debentures, advertising expenses, loss due to unusual occurrences like loss due to fire, theft, and research and development expenses, etc.
DEFERRED REVENUE EXPENSES
There are certain expenses which are revenue in nature (i.e. expenses incurred to maintain the earning capacity of the firm and generate revenue) but whose benefits are received over a period of years generally between 3 to 7 years. It means its benefit is received not only in the current accounting period but over a few consecutive accounting periods.
CHARACTERISTICS
EXAMPLES
ADVERTISING EXPENSES refers to the expenses incurred for promoting the goods or services of the firm through various channels like TV, Social media, Hoardings, etc.
As the benefit of advertising is not received not only in the period when such expenses were incurred but also in the coming few years, it is classified as Deferred revenue expense.
For example – Suppose the company incurred $10 lakh on advertising to introduce a new product in the market and estimated that its benefit will last for 4 years. In this case, $250,000 will be written off every year, for 4 consecutive years.
EXCEPTIONAL LOSSES are losses that are incurred because of some unusual event and don’t happen regularly like loss from fire, theft, earthquake, flood or any other natural disaster, confiscation of property, etc.
Since these losses can’t be written off in the year they occurred they are also treated as Deferred revenue expenditure and are written off over the years.
RESEARCH AND DEVELOPMENT EXPENSES are expenses incurred on researching and developing new products or improving the existing ones. Its benefits are received for many years and thus are classified as Deferred revenue expenses.
For example – Expenses incurred on the creation of intangible assets like patents, copyrights, etc.
PRELIMINARY EXPENSES are those expenses which are incurred before the incorporation and commencement of the business. It includes legal fees, registration fees, stamp duty, printing expenses, etc.
These expenses are fictitious assets and are written off over the years.
TREATMENT
It is debited to the P&L amount (amount written off that year) and the remaining amount on the Aeest side of the Balance Sheet.
In the above example of advertising expenses, in Year 1, $250,000 will be debited in the P&L A/c and the remaining amount of $750,000 is shown on the Asset side of the Balance Sheet.
In Year 2, $250,00 in P&L A/c and the remaining $500,000 in Balance Sheet.
In Year 3, $250,000 in P&L A/c and the remaining $250,000 in the Balance Sheet and in the last Year 4, only the remaining amount of $250,000 in P&L A/c and nothing in the Balance Sheet.
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