How to Analyze Prepaid Expenses and Other Balance Sheet Current Assets
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 which act as placeholders for assets the company expects to generally either receive or use up within one year.
This group of current assets includes prepaid expenses, along with other typical current asset accounts such as cash and equivalents, accounts receivable, and inventory.
In the course of everyday operating activities, many firms set aside money, or effectively pre-pay for goods or services before they actually receive delivery of them. This includes 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, although 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 rental agreement, 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, and 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
Depending on what a prepayment covers, you might 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, for example, there's a risk that the landlord could terminate the lease before those 12 months are up, and 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 pre-paid.
In this situation, the bankruptcy court would convert the person or firm making the prepayment into a general creditor who had to get in line with other creditors to wait for a payment 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, this includes:
Cash and Equivalents
This includes 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 necessary.
This 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 possibility they never will be received. Companies frequently build a just-in-case cash reserve.
These are debts owed to the company, payable within one year. The remaining portion of the note, if longer than one year, resides in the long-term assets section of the balance sheet.
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 6 months.