Current assets are all the assets of the company which are expected to be used, sold, or consumed within one year. Current assets are those assets that can be converted into cash easily. For example - Inventory, Accounts Receivable, Cash, and Cash Equivalents. Loose tools are parts of machinery or sRead more
Current assets are all the assets of the company which are expected to be used, sold, or consumed within one year. Current assets are those assets that can be converted into cash easily.
For example – Inventory, Accounts Receivable, Cash, and Cash Equivalents.
Loose tools are parts of machinery or spare parts of machinery. Loose can be classified on the nature of use whether it is a fixed asset or a current asset. If loose tools are used regularly or within one accounting year, it is classified as a current asset.
Loose tools are usually classified as a current asset, however, there is one exception i.e it is excluded from the current ratio.
They are excluded from the current ratio because the current ratio takes into account only current assets, and the nature of loose tools is either a fixed asset or a current asset and can’t be converted into cash easily.
The current ratio is calculated to check the liquidity of the company.
Loose tools appear in the Asset Side of the Balance Sheet under the head Current Asset, subhead Inventories.
The extract of the Balance Sheet is as follows:
When the balance sheet prepared under Schedule III loose tools is shown under notes to accounts under sub-head Inventories on the asset side.
When the balance sheet is in a T format loose appears as a current asset after recording fixed assets on the asset side.
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Prepaid expense means a service to be rendered in the future period for which the business has already paid the remuneration. Prepaid expenses are classified as assets. The benefits of this payment will accrue to the business at a later period. For example, insurance is often paid for annually on tRead more
Prepaid expense means a service to be rendered in the future period for which the business has already paid the remuneration. Prepaid expenses are classified as assets. The benefits of this payment will accrue to the business at a later period.
For example, insurance is often paid for annually on the basis of the calendar year. A business may pay insurance every year on 1st January for that entire year. While preparing the financial statements on 31st March, it will recognize the insurance premium for the period 1st April to 31st December of the next financial year as a prepaid insurance expense.
Why are prepaid expenses classified as assets?
First of all, let us understand what an asset is. An asset is anything over which the business has ownership rights and which it can sell for money. The benefits of this asset should accrue to the business.
In light of this definition, let us analyze prepaid expenses as an asset. As the business has already paid for these goods or services, it becomes a legal right of the business to receive the relevant goods or services at a later date. As the benefit of this expense would accrue to the business only at a later date, the prepaid expenses are classified as an asset.
Some examples of prepaid expenses are prepaid insurance, prepaid rent etc
Treatment of Prepaid Expenses
Prepaid expenses are recorded in the balance sheet under the heading “Current Assets” and sub-heading “Other Current Assets”
As per the Generally Accepted Accounting Principles or GAAP, expenses must be recognized in the accounting period to which they relate or in which the benefit due to them is likely to arise. Thus, we cannot recognize the prepaid expenses in the accounting period in which they are incurred.
Prepaid assets are classified as assets and carried forward in the balance sheet to be debited in the income statement of the accounting period to which they relate.
Adjusting Entries
Adjusting entries are those entries that are used to recognize prepaid expenses in the income statement of the period to which they relate. These entries are not used to record new transactions. They ensure compliance with GAAP by recognizing the expenses in the period to which they relate.
Conclusion
The GAAP and basic definition of an asset govern the treatment of prepaid expenses as an asset. The business incurs them in an accounting period different from the accounting period in which their benefit would accrue to the business. The business has a legal right to receive those goods or services.
The business carries them as a current asset on the balance sheet. In the relevant accounting period, they are recognized in the income statement.
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