How to Analyze Prepaid Expenses and Other Balance Sheet Current Assets

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While reviewing a company's balance sheet, you'll likely notice a "current assets" section at the top of the schedule. Within this category, companies have some fairly standard accounts that act as placeholders for assets the company expects to receive or use up within one year.

This group of current assets includes prepaid expenses. Other current asset accounts include cash and equivalents, accounts receivable, and inventory.

Key Takeaways

  • "Current assets" is a section on a company's balance sheet that often includes prepaid expenses.
  • Prepaid expenses are the money set aside for goods or services before you receive delivery.
  • Other current assets are cash and equivalents, accounts receivable, notes receivable, and inventory.

Prepaid Expenses

In the course of daily operation, many firms set aside money for goods or services before receiving them. It's like they are pre-paying. These include items like employee labor, which the company records into a prepaid salaries account until it cuts pay checks.

Companies pre-pay many other types of expenses, including taxes, utility bills, rents, insurance, and interest expense.

These may be pooled together and listed on the balance sheet under one "prepaid expenses" heading. Still, each prepaid item is typically recorded in its own account within the company's general ledger accounting system.

Prepaid Expense Example

Consider a retail store that moves into your local mall, signs a lease, and pays 12 months of rent in advance. If the monthly rent is $2,000, the store would show the total advance rent payment of $24,000 on its balance sheet under prepaid expenses.

Each month, the firm would deduct $2,000 from its prepaid expenses on the balance sheet, transferring the amount to a monthly rent expense line on the income statement. By the end of the year, the full $24,000 would show as various expenses on the income statement. There would be $0 left in the prepaid expense asset account shown in the current asset section of the balance sheet.

Prepaid Expenses and Risk

You can be exposed to a degree of risk if the party you prepaid never delivers. If the retail store in the previous example pays a full year's rent, there's a risk that the landlord could terminate the lease before those 12 months are up. The landlord might keep—or attempt to keep—all of the retail store's prepaid rent money.

Unless there is a legal requirement directing the recipient of the payments to keep the prepaid funds in an escrow account, that firm or individual could file for bankruptcy and not be in a position to deliver the goods or services for which the purchaser had prepaid.

In this situation, the bankruptcy court would convert the person or firm making the prepayment into a general creditor. They would get in line with other creditors to wait for a distribution during a bankruptcy proceeding.

Other Current Assets on a Balance Sheet

Other current assets consist of assets that are either owed to the company within one year or likely to be used within one year. Aside from prepaid expenses, these include:

Cash and Equivalents

These are the company's cash in bank accounts, received but undeposited checks, savings and money market accounts, and liquid investments such as Treasury bills. This "cash on hand" can be available quickly if needed.

Accounts Receivable

This category includes payments not yet received from customers for sales made on credit terms. Because accounts receivable are not yet truly in the bank, there is a chance that they never will be received. Companies often build a just-in-case cash reserve.

Notes Receivable

These are debts owed to the company, payable within one year. The rest of the note, if longer than one year, resides in the long-term assets section of the balance sheet.

Inventories

For non-service companies, the inventory account contains components that haven't yet been converted into products, and finished goods that haven't yet been sold to customers. So a manufacturing company would classify its finished goods, works in progress, and raw materials as separate line items on the balance sheet.

Just because a company has inventory on its balance sheet, the true value of this inventory depends on the length of its shelf life. For example, a food manufacturer may have an ingredient in its inventory that cannot be used after six months.