Category: Assets

[vc_row][vc_column][vc_column_text]So today’s question is, how to handle prepaid transactions in accounting & bookkeeping. There are below important points in handling prepayments:

First of all, you need to ‘identify’ a prepaid transaction. A prepaid transaction occurs when you have made the payment, but you have not received goods and services in consideration of that payment. Alternatively, you’ll be delivered those goods or services over a while and not instantly upon payment.

A prepaid expense is represented under current assets in the balance sheet. Once the prepaid cost is utilized, it is presented as an expense in the income statement.

 

 

General examples of prepaid expenses

Following are some generic examples of prepaid expenses:

Rent paid in advance:

Usually, office and building rentals are paid by businesses in advance for three months or six months or sometimes for one year. So, let’s say if you have spent six months’ rent on 1 January for the period from 1 January to 30 June, you need to record this transaction as a prepaid expense on 1 January. Then, at the end of each month, you need to classify one month’s rent as an expense and reduce your prepaid rent gradually. Thus you’ll be passing debit rent expense and credit prepaid rent account entry at the end of every month.

Medical Insurance paid in advance:

Medical insurance for the employees and their dependents are usually paid for one year in advance (or at the beginning of the insurance period). Therefore, at the beginning of the insurance period, the insurance premium paid should be recorded as a prepaid expense and then it should be amortized subsequently at the end of each month as an expense. Same is true for any property or liability insurance.

Subscriptions paid:

If your organization is a member of any trade association or an activity group and you pay annual subscription of that association in advance at the beginning of each year, then, this annual subscription would be considered as a prepayment for one year when paid at the beginning of the year. You need to amortize this payment every month into expenses and gradually reduce the prepayment account.

Prepayments for goods or services:

If a supplier requires to make a prepayment (or advance) for before they can deliver products or services to you, then, this payment of advance to the supplier would be classified as prepayment until goods or services are provided.

Training program:

If a training program of six months is purchased and payment is made in advance, then this advance payment should be booked as a prepaid expense in the balance sheet. This prepayment will be expensed out every month in profit and loss.

Software fee:

If you have purchased a license for a software for one year (or less), then you can book this amount as a prepaid and charge it out to P&L every month.

Trade license:

In certain countries, a trade license is issued at a high cost for a year. This trade license cost should be recorded as prepaid and then monthly expensed out.

 

 

One comprehensive example of prepayment

For example, if you have to place an order for delivery of 500,000 blocks for your next construction project and the supplier of construction material provider has asked for an advance payment of 25% of the value of the order before he can accept the order. Now, let’s say today is 28^th of the month, and you place this order with advance payment of (say) $1,000. You make the payment, and now you want to record this transaction. The delivery of the blocks will come after 15 days, i.e., in the next month and you need to close your books of accounts, and you also need to record this transaction of payment of $1,000.

Above is an example of prepayment transaction where you have made the payment but you didn’t receive any item regarding the payment, yet. So, you’ll record the transaction as follows:

Debit: Advances to suppliers account (a type of prepaid accounts) $1,000

Credit: Bank account $1,000

The ‘advances to suppliers’ account is a general account for any supplier to whom advance is given. This account is one example of prepaid accounts. If you don’t have an advances to suppliers account, you can use a general ‘prepaid expenses account’ also. However, the important thing is, this payment should be classified as a debit amount in the month-end financial statements.

Now, when the construction blocks are received in the next month, you need to record the transaction of receiving blocks. The accounting entry would be as follows:

Debit: Construction material account $1,000

Credit: Supplier payable account $1,000

Now, with the above entry, the receiving of the material is recorded. However, currently, we have a payable to supplier account and a receivable from supplier account (in advances to supplier account). Now, we need to knock-off these two accounting entries to clear the prepayment.

Now, we’ll pass below entry:

Debit: Supplier payable account $1,000

Credit: Advances to supplier account $1,000

This above accounting entry will nullify our prepayment, and thus we’ll have nil balance in our prepayment account.

A short way could have been to credit advances to supplier account debiting material account directly. However, in that case, we would not find any entry in the supplier’s account if we needed to check at a later stage whether we had any transaction or payment to this supplier.

The above was a comprehensive example of one prepayment.

 

Further important points

It is essential to understand why we have to book payments are prepayments and then reverse these payments later at the time of delivery of goods and services. This accounting treatment is to ensure that we present our financial assets and liabilities correctly in our financial statements. If we have only made the payment and have not received the service, then this payment is an advance and should be classified as a current asset in our balance sheet. However, if we have received requested goods and services, then those payments are expenses (or sometimes assets) and therefore, should be correctly classified.

Sometimes, people get confused about advances and prepayments. All advances are not prepayments. For example, advances paid to staff for their personal needs are not prepayments. So, the rule is, if advance paid will be returned to the business, then it is a simple advance and not a prepayment. However, if the advance paid will not be refunded, instead, some goods will be delivered, or service will be performed, then that advance is a prepayment.

It is essential to differentiate prepayments from securities and deposits. Securities are payments made as a guarantee or collateral; it is a safety for the other party ensuring compliance with the contractual obligations. Deposits are money kept with suppliers’ accounts which are usually returned at the end of the contract period or after a fixed period. We do not amortize securities and deposits, as we do with the prepayments.

Accounting for prepayments can be complicated sometimes. You need to prepare a prepayment schedule to keep a record of all the prepayments. Sometimes, annual payments are made in the middle of the year such that payment partially relates to past and future months.  In such cases, ideally, you might have accrued expenses for which payment is made in the middle of the year. Please read our articles on preparing prepayments schedule and accruals accounting for details on handling such complex scenarios.[/vc_column_text][/vc_column][/vc_row]

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Introduction and examples of intangible assets

Intangible assets are those assets which cannot be physically touched. This ‘intangibleness’ is because they do not have a physical presence. Instead, most of the intangible assets have a virtual presence, either in the form of software or something in the understanding of people’s mind.

For example, a movie recorded by a film producer is an intangible asset stored in the soft form in the camera. You may not touch that film physically, but that movie is produced after spending millions of dollars and may have a significant market value.

There are many other examples of intangible assets like:

1. Registered trademark and logo: You would have seen many companies having a small ‘®’ in their trade name or their slogan. This sign represents a registered trademark. That company have spent money on designing, composing and registering this trademark. No other company can use the same trademark. This trademark is an asset which distinguishes this company’s products from other companies’. Therefore, this is an asset for this company and
2. Examples of trademarks and logos are four circles in a row for Audi, five rings (three up and two down) for Olympics, the ‘just do it’ slogan for Nike, slightly eaten apple for Apple and the picture of the founder of KFC for KFC.
3. A brand recognition A book: Yes, it seems that a book has a physical presence, but the value of the book written by a great author doesn’t lie in the physical appearance of the book. The value is in the story or script of that book, that is the intangible part of that asset. The actual price of the book may be a few dollars, but the copyright of publishing that book or the intellectual property of that book may have the value in millions.
4. A software: A software doesn’t have a physical presence, although we can see it on computer screens, and we may purchase software for a few dollars as a retail customer, but having the right to sale that software is an intangible asset worth millions. Similarly, the person who produced that code for the creation of software possesses a significant value as an intangible asset in the form of programming of that software.
5. A chemical formula: let’s say that a company devised a specific chemical formula which is helpful in producing any substance or medicine or product, then that chemical formula is also an intangible asset, i.e., the knowledge of that chemical formula is an intangible asset which can be capitalized (if conditions are met). For example, the recipe to prepare Coke drink is secret and is an intangible asset of Coca-Cola.
6. A photograph taken from an ordinary mobile or camera may also be classified as an intangible asset if that photograph is hugely appreciated and liked. Now, the picture would be saved in the computer; thus, it is intangible, but due to its high likeness, it may be sold with copyrights. Many photographs are being sold on shutterstock.com and similar websites. This is the trading of intangible assets.

 

 

Recognition of intangible assets

Question:

Can all intangible assets be recorded as assets in the balance sheet of a company?

Answer:

No, both as per US GAAP and IFRS, there are certain conditions which need to be met for recognition of intangible assets. Once these conditions are met, then only an intangible asset can be recognized on the balance sheet of a company.

 

Conditions under IFRS are:

The first condition is that the cost of the asset should be measured reliably; this means that the cost incurred to create or prepare that intangible asset should be measured reliably. If it is not clear that which costs have incurred or if no expenses have incurred, the intangible asset cannot be recognized.

It is essential to reiterate the point that any internally generate asset can only be recognized at the cost. For example, if an asset is manufactured/designed/prepared for $1,000 then the asset would be recognized at the cost of $1,000 only. We cannot recognize an asset at a value higher than it’s original cost.

The cost would include direct labor and direct material etc. less any disposal value. For example, if in making a movie, actors were paid amount X and some furniture was purchased for amount Y, and this furniture was later sold at amount Z then in this case, the amount capitalized as an intangible asset would X + Y – Z.

The second condition is that it is probable that future economic benefits will flow to the entity. Now, the future economic benefits will flow to the entity only if that asset is technically feasible and commercially viable. This means that the asset should have technical feasibility, i.e., the product or item on which you are working to build, it should be technically feasible. You should not be investing in something which is not possible. IFRS doesn’t allow the recognition of such intangible assets. For example, if you are trying to build a formula to convert sand into gold and you are spending money on it, and you can measure the cost incurred, but this is something which is not technically feasible. So the investment on formula of converting sand into gold cannot be recognized as an intangible asset.

Further, as stated above, the product should be commercially viable. This means that there should be a market demand for this asset and it should be sold at a value which would be beneficial for the company. For example, customers should be willing to purchase this intangible asset (or any product made using this intangible asset) at a price which is beneficial for the company.

However, in exceptional circumstances, if the technical feasibility is established and there are successful results, then that formula can be recognized as an intangible asset.

Other than the regulations and rules, let’s talk about some practices about intangible assets. Do companies always want to recognize intangible assets? No, not necessarily. Especially if the amounts are small, companies and management would prefer to charge out this expenditure in profit and loss account. This accounting approach is adopted because recognition would lead to further requirements such as calculation of amortization in small amounts every year.

All intangible assets (other than goodwill) need to be amortized over their useful life. Amortization is simply another name for depreciation. However, the depreciation is for tangible assets, while amortization is for intangible assets. This is the difference between amortization and depreciation.

If it has been established that accounting entries need to be passed and asset needs to be recognized, then initial recognition of intangible assets should be recorded as Debit: intangible asset and Credit: Bank (for the amount spent on intangible asset).

Goodwill is the most famous example of intangible assets. However, it is a unique kind of intangible asset. Goodwill is the market value of the name of a brand. Let’s say that you purchase an iPhone just because of the goodwill of Apple. This is something other than all other tangible and intangible assets. Please read our detailed article on goodwill to understand it’s nature, calculation, impairment etc.

It is important to note that financial assets (stocks, shares, debentures, loans, receivables, etc.) are not generally classified as intangible assets. They are separately dealt with as financial assets and have their separate accounting treatments.[/vc_column_text][/vc_column][/vc_row]

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Impairment by definition:

“Impairment is a factor which hampers the ability of an asset to yield future economic benefits.”

Didn’t get it? Ok, let me simplify it for you. Impairment makes assets less usable. This means, after the impairment, the asset will not be as useful as it was before the impairment happened.

For example, if a car gets damaged in an accident, it’s market value may decrease. Also, its ability to generate future cash flows may also decrease. Both these factors result in a decrease in the ability of the car to generate economic benefits and is thus impairment of the car.

In accounting terms, an asset is impaired if its net book value exceeds the present value of its future cash flows. (this will be explained further in the calculation of impairment)

 

Key Features of Impairment:

• Impairment is not a necessary happening with every asset. Some assets may complete their useful life without any impairment.
• Impairment is a very subjective term and would require special examination or detailed analysis to find out the value of impairment. Different experts may determine a different amount of impairment depending on what assumptions have been keyed in the analysis.
• Impairment may result either in a loss in the market value of the assets OR the reduction in the flow of economic benefits from that asset OR both.
• There may be different causes of impairment like physical damage or decrease in the market value or decision of the management or loss of reputation or some regulatory or government directives.
• Both tangible and intangible non-current assets may get affected by impairment
• Charging impairment (where appropriate) ensures that assets are not overstated in the statement of financial position of the entity.
• What’s best about an asset whose net book value is zero? There won’t be any impairment on it

 

Accounting treatment

Impairment is an expense which results in a credit entry in the asset’s account and debit in the impairment expense account. This area is dealt in detail with IAS 37 “Impairment of Assets.”

Debit: Impairment expense account (P&L)

Credit: Asset cost account (B/S)

This accounting treatment is in contrast to the depreciation where there is no accounting entry passed in the asset account directly.

 

 

Indicators of impairment

Sometimes the impairment may be quite visible, i.e., physical damage to the asset due to some accident or natural calamity. However, in some cases, impairment is not entirely visible. Below are some of the indicators which may suggest that an impairment has occurred.

1. In-house or external development of an alternative process/machine
2. A decrease in the market demand of the product(s) produced by the asset
3. A release of an updated model of the product by the vendor
4. Decrease in the useful life of the asset due to an external factor
5. A partial or full ban by regulators on the products manufactured through the asset
6. Physical damage to the asset
7. Leakage of the secret product formula which created a competitive edge
8. Attack of infectious viruses which lead to malfunctioning of the software
9. Obsolescence of the technology which was used to develop the asset
10. Development of a better software by the vendor or the competitor
11. Theft of the base code by hackers

Last 4 points in the above list are related to software/intangible assets.

 

Calculation of impairment

In order to calculate impairment, first, check if the net book value of the asset is higher than its recoverable value. The recoverable value is calculated by taking higher of

1. the value in use, and;
2. fair value less cost of disposal.

Calculation of value in use of the asset may not be simple always and may require several complex calculations.

On a general note, adopt the following step-wise-approach:

1. Estimate future cash flows specifically attributable to the asset/CGU (Cash Generating Unit)
2. Use appropriate discount rate to calculate the net present value of the asset/CGU
3. Ensure that all irrelevant and non-incremental costs/revenues are not included in this calculation

Fair value less cost of disposal is rather easy to calculate in the sense that a market rate of the similar asset/similar deal is taken and any selling expenses (i.e., commission, advertisement, necessary repair, loading/unloading, etc.) are deducted from the sale proceeds.

Let’s take the following example to understand the above concepts:

A company has purchased a machine for $100,000 which has a useful life of 4 years. The company uses straight-line depreciation method. At the beginning of year 4, this machine started malfunctioning due to electric shock, and now it is estimated that its production ability is reduced to half.

If the machine is used in business, it’ll generate an annual profit of $20,000 in the fourth year with nil residual value. If the machine is sold immediately, it will be purchased by a scrapyard for $16,000 after paying a commission of $500.

What will be the impairment charge at the beginning of year 4?

Let’s take a step-wise approach:
Steps 1: Calculate net book value of the asset: i.e., After 3 years of depreciation $75,000 ($25,000 x 3 years) the net book value will be $25,000 ($100,000 – $75,000) at the beginning of year 4.

Step 2: Calculate recoverable value which is higher of:

1. The value in use: Value in use, in this case, is $20,000
2. Immediate disposal proceeds less cost to sell: in this case is $15,500 ($16,000 – $500)

Thus the recoverable value of the machine is $20,000.

Step 3: Compare answers to step 1 and 2 and see if net book value is higher or low than the value in use. As net book value is $25,000 and the recoverable value is $20,000, there is an impairment charge of $5,000.

 

 

Reversal of impairment

It some rare cases, it is allowed to reverse the impairment charged on an asset/CGU. Reversal of impairment may result due to any of the following factors:

1. Revised estimates of the remaining useful life of the asset indicating improved useful life
2. Improvement in the production capacity of the asset due to better operations or maintenance
3. Increase in the market value of the product which is being produced/manufacturing using the asset under review
4. Other factors which may logically depict reversal of the impairment

It is worth mentioning that the reversal of the impairment can be up to a maximum extent of the impairment charged earlier. Let’s say if impairment was charged on an asset of $5,000, then the maximum reversal of this entry can be only up to $5,000 and not more than that (however, less than $5,000 reversal of impairment is allowed).

 

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