A prepaid expense is an expense paid in the present financial period but will be incurred or utilized in a future financial period. The matching principle however demands that revenue for a particular accounting period be matched with the expenses for that period for the books to reflect the correct accounting profit for the period. Expenses relating to a future accounting period are thus classified as prepaid expenses separate from other expenses incurred in the financial period hence a need for adjustment if they are included in the current period expenses.
- An example
A firm could be caring out its business in rented premises. The rental terms may require that the business pays rent for several periods in advance say three years in advance. If the firm is required to pay $ 1,000 as rent annually, it will have to pay $ 3,000 at the beginning of the first year of occupation of the premises. If for example the firm first occupied the premises on January 1, 2014, and paid the $ 3,000, the accountant would debit the rent account by $ 3,000 and credit the bank account by $ 3,000.
If the accountant does not consider prepaid expenses on December 31, 2014 at the end of the financial year, he would write of the whole amount by crediting the rent account and debiting the income statement by $ 3,000. This is wrong because only $ 1,000 relates to the current period and $ 2,000 belongs to years 2015 and 2016. Thus the profit for year 2014 would be understated by $ 2,000. A prepaid expense is an asset to the firm hence this error also understates assets by $ 2,000.
To correct this error, the accountant would have to credit the income statement by $ 2,000 as prepaid rent in order to eliminate the erroneous deduction made. He would then debit the prepaid rent account by $ 2,000. On December 31, 2014, the balance carried forward on prepaid rent account would therefore be $ 2,000. This balance will be transferred to the balance sheet under current assets.
Alex handled the situation properly. Firstly, he was managing personal finances therefore he would not be expected to strictly adhere to accounting rules such as matching his income with his expenses. The $ 296 gain would thus be perceived as an unexpected win fall gain. Secondly, the two firms were businesses operating under professional codes of conduct. They must therefore adhere to recruitment rules and accounting principles. If the two companies had booked interviews with Alex, both must have been ready incur recruitment costs and must have set aside some funds to meet such costs as out of the pocket expenses.
Given the first firm is not related to the second one and were not aware they were interviewing the same person, both would be expected to meet their recruitment costs separately hence both would be expected to pay for the out of pocket expenses. To discern this further, one would consider a situation whereby the two firms had to interview a person but instead of Alex, they invite two different people. In this case, each would have to pay for the out of pocket expenses for each interviewee irrespective of whether the other firm paid the expense or not. The key point is, the two firms are independent and must meet their costs independently. If Alex was providing services to the two firms, they would both have to pay him as two separate entities.