Discussion:Debit: Prepaid Expense -- Credit: Accrued Expense ??

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Discussion Forum Index --> Accounting Questions --> Debit: Prepaid Expense -- Credit: Accrued Expense ??


Wiles (talk|edits) said:

19 November 2013
GAAP (or FKA GAAP) Question:

Corporation year ends December. In July, they sign a 12-month insurance contract for coverage extending July - June. Insurer sends them a bill in July for the whole 12 months and also offers them a monthly payment option with interest.

What do they book in July? It seems that they have created an obligation for the full 1-year payment by signing the insurance contract. Do they book the whole year accrued expense in July, debit 1 month of expense and debit 11 months as a pre "paid"?

Nilodop (talk|edits) said:

20 November 2013
I do not know the GAAP answer, but it seems that if you do not show it the way you describe, there are misstatements of the facts, such as omission of the liability. I guess the ability (if it exists)to cancel the insurance (and thus the obligation) could enter into it.

Captcook (talk|edits) said:

20 November 2013
They must record 1/12th of the policy cost in each month of the year.

What you haven't told us is whether they paid it all up front or in installments.

To make the math easy, let's assume the annual policy cost is $12,000. Every month will have insurance expense of $1,000. If it is paid all up front in July, you will have a prepaid expense of $11,000 on July 31. This PP will decrease every month as the debit is moved from the asset account to the appropriate expense account. If it is paid on installments, an accounts payable should be recorded the 1st of each month and removed from the balance sheet when paid. If that monthly bill is not paid, then you may have an accrued expense (via A/P) until the bill is paid.

Nilodop (talk|edits) said:

20 November 2013
No matter how we answer Wiles, he will of course record 1/12th each month. His question, as I read it, is purely balance sheet related. And while it is true that OP has not stated clearly whether or not they "paid it all up front or in installments", there would be no question to ask if it were paid up front. My inference is that OP wants to know whether to record prepaid expense (more accurately, deferred expense) and a liability (accrued expense or accounts payable). If they do not so record it, and assuming materiality, I think there is a misleading balance sheet, in that the liability is not shown.

The practical aspects are that it is probably immaterial, and it makes no difference as long as the monthly expense gets recorded. But wouldn't a careful reader of the financials wonder where the interest expense came from, absent a recorded liability?

As I said above, I do not know the GAAP answer, but my view is a common-sense one.

Wiles (talk|edits) said:

20 November 2013
I have not read the fine print of the contract. My understanding is that they signed an insurance contract for the next 12 months and the premium is due and payable up front. However, they can make monthly payments that tack on a nominal extra charge. It seems that the signing of the contract has created an obligation, a liability on Day 1 for the whole premium.

Nilodop (talk|edits) said:

21 November 2013
I agree.

Wiles (talk|edits) said:

21 November 2013
It just seems strange to debit Prepaid Expense for an expense that hasn't actually been "paid"? Nilodop, suggests using Deferred Expense instead of Prepaid Expense, but the accounting literature suggests that these two titles are synonymous. The definition for both state that a future expense has been paid.

Captcook (talk|edits) said:

21 November 2013
I would disagree that there is an obligation to pay the entire amount up front because that is one option available to choose. I used to see this type of thing regularly when I was auditing. I've also seen a mix with a "down payment" and a smaller obligation throughout the year. If they pay it up front, there is a prepaid. If they don't, there is no amount prepaid. It seems relatively simple to me.

Look at the flip side. If they cancelled the policy after six months, I would assume the remaining amount would not be due or would be refundable. Either way, the entire amount is not payable in July. It is either paid in July (and recorded as prepaid) or it is payable every month.

Nilodop (talk|edits) said:

22 November 2013
So, if a company buys inventory on terms that allow payment over the following 12 months, and further allow credits for returned inventory, do they only record the inventory that they have paid for? NO liability?

Captcook (talk|edits) said:

22 November 2013
You're mixing apples and oranges. You can only "take title" to insurance as the coverage period elapses. What is the underlying substance of a return? If you immediately know you will return a specific number of items, you will not have taken title to those items and should not record inventory/payable for them.

If you want to use an inventory example, how about I consign 12 items with you to sell. At the end of every month that passes, you must buy one of the remaining items from me and take title to it. If none sell, you will have taken ownership to 12 items in a year. If all sell in the first month, you took ownership of none of them. Either way, you have an agreement signed in month one in which the title to no greater that one item will pass each month for the next twelve months. When title passes, the payable and related debit (expense/inventory) is recorded.

Nilodop (talk|edits) said:

22 November 2013
I guess someone needs to answer OP. What is the GAAP rule?

Wiles (talk|edits) said:

22 November 2013
Perhaps the signing of the contract has created a "contingent liability". However, my 20-year old Intermediate Accounting book says that a contingent liability should only be accrued if it is (1) probable, (2) reasonably estimable, and (3) the event has taken place. Otherwise, the contingent liability only needs to be disclosed. It seems that #3 has not occurred. Therefore, no accrual.

Nilodop (talk|edits) said:

22 November 2013
How is it contingent? If they cancel, won't they replace it with other insurance?

Nilodop (talk|edits) said:

22 November 2013
I do not know how well-researched or respected is this website: http://www.accountanttown.com/site/accounting-principles-deferred-expense, but it contains this language relating to our topic: "If we are to be precise we shall probably call them deferred charges to expense, since this term seems most accurately to describe them. They are expense items wherein the act of charging them to expense accounts, which accounts will be in turn closed out to profit and loss has been deferred to a subsequent period giving to them the effect of assets. This group comprises insurance, taxes, rent, advertising, organization expense, development expense, moving expense, etc.

It is quite usual to look upon these items as in the nature of prepaid expenses. They may be prepaid in many cases. However, it should be pointed out that the matter of prepayment does not enter into the proposition. They are to be considered as assets if the corresponding liability has been taken up whether or not it has been paid." (Emphasis mine).

Nilodop (talk|edits) said:

23 November 2013
I surrender. I consulted with a former chairman of the FASB, who says no liability should be set up. It pains me, but I am wrong.

Bushmaster (talk|edits) said:

18 February 2014
Agree with the former chairman. If the world ended at the end of the month, you have either overpaid for insurance and due a refund, underpaid and owe, or paid the correct amount. In the example above, $1000 per month would get charged to insurance expense.

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