How to Read a Financial Report, 10th Edition

9OPERATING EXPENSES AND PREPAID EXPENSES

Paying Certain Operating Costs before They Are Recorded as Expenses

Please refer to Exhibit 9.1, which highlights the connection between operating expenses (including selling, general, and administrative expenses and research and development expenses) in the income statement and the prepaid expenses asset account in the balance sheet. This Chapter explains that operating expenses generate this particular asset of a business.

Chapters 11 and 12 explain that some operating expenses are recorded before they are paid. This is done by recording a liability for the unpaid expenses. This chapter, in contrast, explains that certain operating costs are paid before the amounts should be recorded as expenses. In short, businesses have to prepay some of their expenses.

Insurance premiums are one example of prepaid expenses. Insurance premiums are paid in advance of the insurance policy period—which usually extends over 6 or 12 months. Other examples are office and computer supplies bought in bulk and then gradually used up over several weeks or months. Annual property taxes may be paid at the start of the tax year; these amounts should be allocated over the future months that benefit from the property taxes.

Cash outlays for prepaid costs are initially recorded in the prepaid expenses asset account that acts as a holding account. Then the amounts are gradually charged out over time to operating expenses. This two-step process is the means of delaying ...