Prepaid Expenses: Accounting
I understand that if a company (Let's call it Rover) pays 3 months of rent for an office space in advance, it's called a prepaid expense. In this case, the income statement doesn't change since Rover hasn't started using the office space yet (it's not expensed until Rover starts using the rental space in month 1, 2, 3). However, the cash flow changes since Rover paid in advance. Thus, we make cash adjustments to reflect this. If the net income (assuming nothing else changed) was 100 and Rover paid 60 in cash for the office space, the net cash is now 100 - 60 = 40.
Thus, I understand that prepaid expense increased, so we adjust the cash down to reflect how much cash Rover actually generated in this period.
Question: If prepaid expenses decrease as Rover starts using the office space in month 1, why would cash increase? We paid 60 upfront and we are not getting the cash back, why would we increase the net change in cash?
Net Income: 100
change in Prepaid Exp: 20
Net change in cash: 120
More specifically, I am referring to a cash increase in the cash flow statement
You would need to add back the prepaid asset amortization (expense in I/S) because its dragging down your net income, but it had zero cash effect. Think of it this way, imagine in that second year, you made one cash sale for $120, and had the prepaid asset amort. of $20. Your net income is $100 ($120 rev minus $20 expense).
What was your cash inflow that period? $120. Thus, when starting your C/F statement with NI of $100, you need to add the change in the prepaid asset account of $20 to arrive at cash flows from operations.
Hope that helps.
More simply, the amortization of the prepaid asset doesn’t impact cash at all.
If you credit the asset for $20, you debit the rent exp for $20. That’s it. Income has no direct impact on cash.
Prepaid Expenses_Accounting (Originally Posted: 05/30/2018)
I understand that if a company (Let's call it Rover) pays 3 months of rent for an office space in advance, it's called a prepaid expense. In this case, the income statement doesn't change since Rover hasn't started using the office space yet (it's not expensed until Rover starts using the rental space in month 1, 2, 3). However, the cash flow changes since Rover paid in advance. Thus, we make cash adjustments to reflect this. If the net income (assuming nothing else changed) was 100 and Rover paid 60 in cash for the office space, the net cash is now 100 - 60 = 40.
Thus, I understand that prepaid expense increased, so we adjust the cash down to reflect how much cash Rover actually generated in this period.
Question: If prepaid expenses decrease as Rover starts using the office space in month 1, why would cash increase? We paid 60 upfront and we are not getting the cash back, why would we increase the net change in cash?
Net Income: 100
change in Prepaid Exp: 20
Net change in cash: 120
More specifically, I am referring to a cash increase in the cash flow statement
Because you're adding back a non-cash expense. After month 1, you incur 1 month of rental expense right? That expense flows through the income statement but since the cash for that expense was already paid in advance, the expense that incurred is actually non-cash, so you add that back to get a sense of the actual change in cash.
Thank you for the helpful comment! If today I was accounting for inventory, when inventory is being used is it recorded as an expense on the income statement as well?
Yeah inventory would be reflected in Cost of Goods Sold and be incurred at the moment of sale
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