Question 3.8: Domestic Ltd pays rent for its premises quarterly in advance...
Domestic Ltd pays rent for its premises quarterly in advance (on 1 January, 1 April, 1 July and 1 October). On the last day of the accounting year (31 December), it pays the next quarter’s rent to the following 31 March ($3,000), which is a day earlier than required. This means that a total of five quarters’ rent has been paid during the year. If the business reported the cash paid in the income statement, this would be more than the full expense for the year. This treatment would also contravene the matching convention and the transaction recognition criterion, because a higher figure than the expenses associated with the income of the year would appear in the income statement.
This problem is overcome by dealing with the rental payment as follows:
- Reduce cash to reflect the full amount of the rent paid during the year (i.e. 5 × $3,000 = $15,000).
- Show the rent for four quarters as the appropriate expense in the income statement (i.e. 4 × $3,000 = $12,000).
- Show the quarter’s rent paid in advance ($3,000) as a prepaid expense under assets in the statement of financial position. It is an asset because it represents future economic benefits in terms of the right to use the rented premises for the first three months of the next year. Please note that this example ignores GST, which would apply to commercial rentals. The prepaid expense will appear as a current asset in the statement of financial position, under the heading ‘prepaid expenses’ or ‘prepayments’.
In the next period, this prepayment will cease to be an asset and become an expense in the income statement of that period when the three months’ usage expires. This is because the rent prepaid relates to that period, and will be ‘used up’ during it. These points are illustrated in Figure 3.3.
prepaid expenses Expenses that have been paid in advance at the end of the reporting period
