Prepaid Expenses and Other Current Assets on the Balance Sheet

Investing Lesson 3 - Analyzing a Balance Sheet

Prepaid expenses
When a company pays its bills before they are due, a prepaid asset is created on the balance sheet under the current assets. That's because the company has the right to receive a good or service; this right is an asset because it has value.. Getty Images

Prepaid expenses on the balance sheet arise as a result of managers and employees conducting ordinary business.  In the course of everyday operating activity, many firms will end up paying for goods or services before they actually receive delivery. If a jewelry store moved into your neighborhood mall, it would most likely have to sign a rental agreement and pay six to twelve months' rent in advance.

If the monthly rent was $1,000 and the business prepaid for an entire year, they would put $12,000 on the balance sheet under Prepaid Expenses ($1,000 monthly rent x 12 months = $12,000). Each month, it would deduct 1/12 from the prepaid expenses, transferring it to a cost line on the income statement.  By the end of the year, the full $12,000 would have been run through the profit and loss as an expense and there would be $0 in prepaid expense assets shown on the current asset line of the balance sheet.

There are many types of prepaid expenses including taxes, salaries, utility bills, rents, or interest expense.  These would all be pooled together and put on the balance sheet under this heading.

Realize that, to some degree and in some situations, there is a degree of counterparty risk in a prepaid expense.  Unless there is some sort of legal requirement that demands the person to whom the bill was paid keep the funds in a segregated escrow account, were the firm or individual to go bankrupt and not be able to deliver the goods or services for which the business had already paid, it could turn into a loss.

 At the very least, it would convert the person or firm making the prepayment into a general creditor who had to fight with other creditors for a distribution during a bankruptcy proceeding.

This isn't so much a concern for giant blue chip businesses, which have experienced management teams and specialists who spend a great deal of time thinking about protecting against such things, but could be worth considering if you own a small business or even if you are a consumer.

 Many years ago in my old hometown, there was a car dealership that had been part of the community for decades.  The man who ran it began to engage in some questionable behavior; behavior that made him insolvent without many people knowing.  The cars were secured by financing received from the automobile manufacturers.  One week, a customer went in and purchased a car or truck for cash.  The dealer didn't hand over the title, the customer wrote a personal check, and agreed to come in sometime in the next week or two to pick up and take possession of the vehicle.  Unfortunately for this customer, between the time the dealership cashed the check and the time the automobile manufacturers repossessed the inventory on the lot, the title had never been completed.  As a result, this man didn't actually own the car or truck for which he had paid and became an unsecured creditor in the bankruptcy proceeding.  

By their very nature, prepaid expenses are usually a small part of the balance sheet.

They are relatively unimportant in your analysis under almost all circumstances and shouldn't be given too much attention unless there is a specific reason you believe they warrant concern.  

Notes Receivable on the Balance Sheet

Notes Receivable are debts owed to the company which are payable within one year.

Other Current Assets on the Balance Sheet

Other current assets are non-cash assets that are owed to the company within one year.

Non-Standard Items on the Balance Sheet

Sometimes companies put items on their balance sheet which aren't standard; perhaps resulting from one-off unique situations that are explained in the 10-K filing.  You have to take these on a case-by-case basis to try and determine the role they play in the overall picture.  As you gain more experience analyzing balance sheets, you'll start to see certain patterns and terms arise from time to time, particularly within a given industry.

To help you with this part, you might want to pick up a copy of Barron's "Dictionary of Finance and Investing Terms". The reference book is relatively inexpensive ($10 or $11), and defines over 4,000 financial terms including many of those found on the balance sheet.  You may also find the "Dictionary of Business Terms" useful as well. It has 7,500 entries covering almost every business definition you could possibly ask to know. While neither is required to do balance sheet analysis, they can save you a lot of time.

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This page is part of Investing Lesson 3 - Understanding the Balance Sheet. To go back to the beginning, see the Table of Contents. If you have already read this lesson, you can skip directly to the Balance Sheet Quiz.

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