Prepaid Expense to When Expense is Recognized 3FS (NWC question)
On the BIWS: "A company prepays $20 in utilities one month in advance. Walk me through what happens on the statements when the company prepays the expense, and then what happens when the expense is recognized, combined with the first step. 25% Tax Rate.
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Step 1 makes sense, where the IS remains unchanged, CF is down by $20 (due to an ASSET increase), and the asset side on the BS has cash down $20 and Prepaid up $20 balancing.
On the second step however, I am confused about the BS cash impact. On the IS, expense is up $20, so pretax is -$20 and NI is -$15.
CF, NI is -$15, and because the Prepaid Asset decreases from $20->$0, doesn't cash increase by $20? NWC is up $20 because an asset fell $20 which should be added here. I am confused because the BIWS says that even though the Prepaid Asset reverses, there is no NWC impact. I'm not sure why this is the case and would love an explanation.
Thank you
1. Debit Prepaid Expense $20 (Asset) and Credit Cash $20 (Asset). No net change to assets, liabilities, or equity. Just transforming an asset into another asset.
2. Debit Expense for $20 (Income Statement) / Credit Prepaid Expense for $20 (Asset). Once income statement sweeps in, retained earnings and assets will both be lower by $20, as these resources have been dissipated to help run the business.
3. Uncle Sam gives you a tax subsidy for your expenditure so cash is debited by $5 and income tax expense is credited by $5 compared to what it otherwise would have been at a 25% tax rate. Your retained earnings equity and assets are $5 higher than they otherwise would have been, but it came at the cost of the initial $20 outlay, so net $15 reduction.
Thanks, super helpful. I get the intuition that there is no need to account for NWC in the CF but why would it be wrong to add the falling asset to the CF? I usually just do IS /CF/BS progression but how would I answer this in an interview? Feel like I'm being braindead
btw, dope username
To the extent cash is need for operations, cash is in NWC. Non-operating cash is considered excessive and is not part of NWC (see enterprise value formula for explanation on this). Prepaid expenses are in NWC. Changing operating cash into prepaids is not NWC-influential. Having prepaids turn into actual expenses will reduce your NWC, but hopefully you will have made some sales and generated some more cash in the interim. It's the circle of life.
Thanks, I thought the username was sweet too. Kelly is a family surname, and I love the Poundstone book. Cheers
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