Prepaid expense examples.
Why would a business owner be interested in prepaying certain expenses for a full year,
rather than paying on a monthly basis?
The answer to that is: discounts!
Here are some examples of discounts that I got offered in my business for paying for
a full year upfront rather than paying on a monthly basis.
1.7% discount on corporate income taxes with the government tax authorities, 2% discount
on insurance, and a 12% discount on my financial newspaper subscription.
Any number that jumps out at you?
Yes, the discount on an annual newspaper subscription versus a monthly subscription is very big.
Every monthly renewal notice would provide an opportunity to switch or cancel, so the
publishing company finds my long term loyalty something they are willing to pay for.
Let’s review one of the other examples in more detail.
Why do I specify that these are nominal discounts?
Let’s run the numbers in the insurance example,
and calculate nominal and effective discount rates.
The default for the insurance company is to charge me in twelve monthly installments of
$150 per month.
12 monthly payments of $150 is $1800 for the year.
Alternatively, I can choose to pay the full year’s insurance fee upfront before the
start of the year.
This charge would be $1764.
The nominal discount offered is $36, and if you divide this by $1800 it equates to 2%
nominal discount.
Is this the right way to look at the discount percentage?
A second perspective is to see the $1800 as an amount that is due anyway, that you pay
down over the year.
That way, the remaining outstanding debt at the end of January is $1650, end of February
$1500, all the way to end of December when the full amount is paid down.
Using this perspective, the average debt for the year is $900
(the June, middle of the year, ending balance).
The effective discount rate equals the nominal discount of $36 divided by the average debt
of $900, which is 4%.
That makes it even more attractive!
I am certainly not getting 4% interest annually in a savings account in the bank!
Now that I have decided to take the full year upfront option, how do I account for it?
A core accounting convention is the matching principle: expenses should be recorded during
the period in which they are incurred.
This is where the balance sheet account of prepaid expenses comes in.
In prepaid expenses, you record the right to receive future services that have already
been paid for but not consumed.
So even though the cash transfer to the supplier (in this case the insurance company) happens
upfront at the start of the year, my expense recording (and by the way also the revenue
recognition on the side of the insurance company) needs to happen on a monthly basis.
Here’s how the journal entries for prepaid expenses work step by step.
We first record the full invoice by crediting cash (money is leaving the company)
and debiting prepaid expenses.
Both cash and prepaid expenses are balance sheet accounts.
Within the asset category, cash goes down and prepaid expenses goes up.
We then transfer $147 of cost in January from the balance sheet to the income statement
by debiting insurance expense and crediting the balance sheet account prepaid expenses.
Same journal entry every month.
It is important to check at the end of the subscription period that the full amount of
the original invoice has now been expensed: is the sum of the debits and credits on the
prepaid expenses asset account the same, and the balance therefore zero?
Discounts for prepaying certain expenses for a full year are worth evaluating!
What’s also worth doing is subscribing to the Finance Storyteller YouTube channel!
Thank you for watching.