Prepaid expenses on cash flow statement
Prepaid expense
In accounting, prepaid expense is a current asset that occurs as a result of advance payment that we have made for goods or services that we will receive in the near future. Likewise, when we make the advance payment, we can make the journal entry for the prepaid expense by debiting the prepaid expenses account and crediting the cash account.
| Account | Debit | Credit |
|---|---|---|
| Prepaid expenses | 000 | |
| Cash | 000 |
This journal entry shows that when we make an advance payment, there is an increase in prepaid expenses (debit). However, at the same time, the cash balance decreases (credit) as a result. Hence, an increase in prepaid expenses results in a negative effect on cash flow.
Later, when we receive the goods or services that we have made an advance payment for, we can make the journal entry for the amortization of prepaid expenses with the debit of the expense account and the credit of the prepaid expenses account.
| Account | Debit | Credit |
|---|---|---|
| Expense | 000 | |
| Prepaid expenses | 000 |
In this journal entry, there is a decrease in prepaid expenses (credit). However, there is no cash involved in this case even though there is an expense (debit) charged to the income statement. This has a positive on cash flow for the current period as there is no cash outflow from the business for the expense consumed.
Cash flow statement
Cash flow statement is a financial statement that reports various cash flows in the company from the beginning to the end of the accounting period. These cash flows come from three main activities including cash flows from operating activities, cash flows from investing activities and cash flows from financing activities.
Cash flows from operating activities are the cash flows that generate revenues and expenses in regular business activities. This is why the schedule of cash flows from operating activities can be prepared with the indirect method by reconciling the net income to net cash.
The reconciliation of net income to the net cash can be done by adding back the non-cash expenses to the net income and making various adjustments by adding or deducting the changes in non-cash current assets and current liabilities.
Meanwhile, cash flows from investing activities are the cash flows that are related to the investment activities such as the purchase and disposal of fixed assets as well as the purchase and sale of debt and stock investments.
And cash flows from financing activities include activities that we use to obtain cash as well as paying back the cash that originates from such activities. These activities include issuing and repurchasing shares of stock for cash, borrowing and paying back money to creditors, paying interest and dividends, etc.
Increase in prepaid expenses on cash flow statement
As we have seen above, an increase in prepaid expenses has a negative effect on cash flow as there is a cash outflow from the business. Likewise, an increase in prepaid expenses will result in a decrease in cash flow for the current period.
In this case, the adjustment for the increase in prepaid expenses on the indirect cash flow statement can be done by deducting the increased amount from the net income in order to arrive at net cash flows from operating activities.
| Cash flows from operating activities | |||
| Net income | xxxx | ||
| Adjustments to reconcile net income to net cash flows from operating activities | |||
| Depreciation expense | xxxx | ||
| Increase in prepaid expenses | (xxxx) | ||
| Increase in non-cash current assets | (xxxx) | ||
| Increase in current liabilities | xxxx | ||
| Net cash flows from operating activities | xxxx | ||
Decrease in prepaid expenses on cash flow statement
On the other hand, a decrease in prepaid expenses has a positive effect on cash flow as there is no cash outflow even though there is an expense on the income statement as a result of the amortization of the prepaid expenses.
In this case, we can make an adjustment for the decrease in prepaid expenses on cash flow statement by adding the decreased amount to the net income in order to determine the net cash flows from the operating activities.
| Cash flows from operating activities | |||
| Net income | xxxx | ||
| Adjustments to reconcile net income to net cash flows from operating activities | |||
| Depreciation expense | xxxx | ||
| Decrease in prepaid expenses | xxxx | ||
| Decrease in non-cash current assets | xxxx | ||
| Decrease in current liabilities | (xxxx) | ||
| Net cash flows from operating activities | xxxx | ||
In summary, we can make the adjustments for the increase or decrease in prepaid expenses on cash flow statement by deducting the increased amount or adding the decreased amount to the net income in order to reconcile the net income to the net cash flows from operating activities.
| Increase in prepaid expenses => deduct the increased amount from net income |
| Decrease in prepaid expenses => add the decreased amount to net income |
Prepaid expenses on cash flow statement example
For example, at the end of the accounting period, we analyzed the changes in non-cash current assets and current liabilities. And as a result, we have a $5,300 increase in prepaid expenses and other changes as in the table below:
| Non-cash current assets | Year 0 | Year 1 | Changes |
|---|---|---|---|
| Inventories | 91,300 | 102,800 | 11,500 |
| Accounts receivable | 32,100 | 38,200 | 6,100 |
| Prepaid expenses | 23,500 | 28,800 | 5,300 |
| Current liabilities | |||
| Accounts payable | 51,200 | 49,300 | (1,900) |
| Accrued expenses | 26,300 | 28,100 | 1,800 |
| Income taxes payable | 11,400 | 13,800 | 2,400 |
Additionally, we have $52,600 net income on the income statement and a $4,800 depreciation of fixed assets had been charged to the income statement as an expense during the accounting period.
Prepare the schedule of cash flows from operating activities under the indirect method of cash flow statement.
Solution:
With the $5,300 increase in prepaid expenses and other information in the example, we can prepare a schedule of cash flows from operating activities under the indirect method of cash flow statement below:
| Cash flows from operating activities | |||
| Net income | $52,600 | ||
| Adjustments to reconcile net income to net cash flows from operating activities | |||
| Depreciation expense | 4,800 | ||
| Increase in inventories | (11,500) | ||
| Increase in accounts receivable | (6,100) | ||
| Increase in prepaid expenses | (5,300) | ||
| Decrease in accounts payable | (1,900) | ||
| Increase in accrued expenses | 1,800 | ||
| Increase in income taxes payable | 2,400 | ||
| Net cash flows from operating activities | $36,800 | ||
So, after the adjustment made on the increase in prepaid expenses and other reconciliation, we have only $36,800 net cash flows from operating activities even though there is a $52,600 net income on the income statement.