Prepaid Expenses

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According to Canada Revenue Agency:
IT-417R2 Prepaid Expenses and Deferred Charges

¶ 2. A prepaid expense occurs where an outlay or expense has been made or incurred by a taxpayer in a particular taxation year and it represents, for example, all or part of the cost of services which will be provided to the taxpayer after the fiscal year end. For example, a premium paid in advance to obtain a fire insurance policy, which provides protection for a period extending beyond the year in which the expenditure was made, is one type of prepaid expense.

Prepaid expenses usually play part-in-parcel with the “Accrual Accounting” concept of accounting and bookkeeping. Expenses are deductible in the business – made in anticipation of profit. Profit would normally be taxed on a fiscal or calendar year basis. The government doesn’t want you to deduct next year’s expenses against this year’s income. It’s common sense.

It makes great sense to consider setting up Prepaid Expenses in your financial statements for two important reasons:

  • To set-up amounts paid for expenses of future years’ income and sales
  • To adjust amounts accrued for expenses in the current year, that relate to future years’ income and sales
  • Here are a few examples of prepaid expenses, assuming your Year-End is December 31.

    You pay your rent of $500 on the 1st of every month. During X-Mas, you give your landlord a cheque for January’s rent and he cashes it on December 28.

    You would want to set-up $500 in Prepaids.

    You pay your Mortgage payment on the 20th day of every month, which includes principle and interest (per some amortization schedule) plus a portion of property taxes. Generally, banks will pay your property taxes on a specific date – and let’s say it is June 30th. Starting with the July payment they want you to pay at least 1/12’th of this amount with your mortgage payment. Let’s say that they paid $2,400 and your new tax amount is $200 extra per month.

    You would want to set-up $200 x 6 = $1,200 Prepaid Property taxes in Prepaids. There may be a separate bank account for the property tax collection and remittance by the mortgage company. In these cases I would include the bank balance with the Prepaid Expenses, not the Cash accounts. By the way, it would not matter what the day of the month the payment was made. The property taxes were paid in full June 30th, all payments made in the calendar year after that is Prepaid for next year.

    You pay your insurance company the annual insurance policy in three payments, May 2, June 2 and July2 … each for $1,500. The term of your insurance is from May 2/xxxx to May 1/xxxx

    In this case, you paid the entire amount, $1,500 x 3 = $4,500. The prepaid portion is the amount of this policy that is good after the year end of December 31 .. from January 1 to May 1 … which is 121 days (122 days in a leap year). The amount of $4,500 x 121/365 = $1,491.78 would be setup in Prepaids.

    Now, in a similar scenario, suppose your annual insurance policy in three payments is due November 2, December 2, and January 2 .. each for $1,500. The term of your insurance is November 2/xxxx to November 1/xxxx

    In this case, you would have only paid for two payments. You can calculate Prepaids in two ways. I may choose to do it either way, but normally that decision is based on keeping it consistent with the prior year. In the first method, you would set-up an accrued accounts payable for the balance owing on the insurance policy (due January 2) and then calculate your prepaid normally as above. In the second method, you just calculate your prepaid based on what you paid. Both ways will give the same expense amount. The portion prepaid will be from January 1 to November 1 or 305 days (306 days in a leap year). For example:

    In this case, the prepaid (if 100% paid) would be $1,500 x 3 = $4,500 x 305 / 365 = $3,760.27 but, you would deduct the unpaid 3rd instalment of $1,500 – so the final prepaid amount would be $2,260.27.

    To check this calculation, do it in reverse. You paid $3,000 less $2,260.27 leaves an expense of $739.73.

    The insurance policy that covers this fiscal year would be from November 2 to December 31 (if paid in full) would be $4,500 x 60/365 = $739.73

    Suppose you are paying your Property Taxes and Business Taxes directly to the City in 12 monthly TIPP (tax instalment payment plan) payments – What happens?

    If your Year-End is also December 31, there wouldn’t be any prepaids in this case. If your Year-End falls on any other month-end date, there still wouldn’t be any prepaids set-up. Your General Ledger already has 12 monthly payments in it.

    Suppose you are payng your Property Taxes and Business Taxes directly to the City in 10 monthly TIPP (tax instalment payment plan) payments, and your Year-End is June 30th – What happens?

    First of all, I would be consistent with the previous year, in determining whether I would set-up a prepaid or not. But, technically, there will be a prepaid amount. It may not be significant, though and you might end up ‘passing’ on the booking of this entry, but you should calculate it at least once in a while.

    Let’s say your taxes is $2,400 per year, you pay over 10 months at $240 per month, and your year end is June 30th. For this scenario, it is better to look at what SHOULD be recorded in the current fiscal year, rather than looking at what amounts relate to future years. In this case, since property taxes are for a calendar year only, the amount of the current years’ property taxes of $2,400 that relate for the period January 1-June 30 would be x 6/12 = $1,200.

    On your TIPP plan, you paid $240 x 6 = $1,440 but only $1,200 should be the expense, so the prepaid amount that you would set-up in this case should be $240.00

    Are the calculation of Prepaid Expenses always this simple HART? 😀

    There are many aspects to Prepaid Expenses, that you should consider – besides … insurance, taxes, and rent. Other examples could be:

  • Prepaid Vehicle Lease Payment, final payment
  • Extended Vehicle Maintenance contracts
  • Prepaid Rental Security Deposit
  • Prepaid Utility Deposit
  • Prepaid Office and Warehouse supplies (if you stock up close to Year-End date)
  • Deposits on Asset Sales not to be finalized until following year
  • Subscription and Membership fees paid in advance
  • This is not a inclusive list of examples, just stuff I normally come across during the preparation of my client’s files and Year-End financial statements.

    Take care.
    HART
    1800HART.com

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