Auditing Prepaid Expenses and Deferred Charges
As an auditor you have to pay attention to all of a company’s assets. Prepaid expenses and deferred charges appear on a company’s balance sheet as other assets. Both categories apply to a situation where a client pays in advance for a good or service.
When you see the words expense and charge, you may wonder how the heck these items belong in an asset account. Expenses belong on the income statement, right? Well, GAAP dictate that expenses that are paid before they’re due belong on the balance sheet. Whenever your audit client pays expenses in the current period that won’t be matched with revenue until subsequent periods, it’s a prepaid expense or deferred charge.
If a company prepays its expenses, it usually has the next 12 months to use up that asset. Businesses prepay their expenses all the time. For example, they often pay a year’s worth of business insurance at once. They may also pay rent and interest expense in advance.
At the end of each month, your client’s accounting personnel need to prepare a journal entry to book the expired portion of the prepaid expense. For example, if the company pays $1,200 for 12 months of insurance, the prepaid insurance asset account is reduced by $100 every month, and the insurance expense account is increased by $100.
Auditing prepaids is usually a simple task. The prepaid expense originates in the purchases process, so good controls in that business process carry over to the prepaid process. Misstatements are normally immaterial and easily fixed with a journal entry.
Your client may have deferred charges, which are transactions that take place and are recorded on the financial statements in the present and are carried forward into the future until they’re actually used. Two examples are relocation expenses and debt issuance costs:
Relocation costs: Your client pays these costs when it packs up and moves shop. Depending on the size of the operation and the distance of the move, the costs can be considerable. Because the benefits of a move presumably will last for many years, the costs involved in the move can be expensed over time (instead of when they’re actually paid). If you see relocation costs on your client’s financial statements, query the client as to the circumstances to see if any necessary cost was appropriately moved to the income statement.
Debt issuance (bond) costs: If your client issues bonds to raise money, the costs associated with the bonds are debt issuance costs. For example, your client has to pay an investment bank to market the bonds to investors and pay legal fees to have attorneys prepare the bond documents. The idea is that the bonds will generate revenue for many years, so the costs associated with issuing the bonds can be expensed over the same time frame.
Corporations raise money either by selling stock (which is classified as equity and doesn’t have to be paid back) or by selling bonds (which are debts and do have to be paid back). If your client sells bonds, it definitely needs to provide adequate disclosure in its financial statements, including the reason for and amount of the bond issuance, the time in which the bonds need to be paid back, and the interest rate.