Chapter 1
Financial Statements: Personal Accounting
18
Figure 1.32 illustrates another example of a prepaid expense. Assume that you hire a gardening
service that costs $600 per year ($50 per month).The service provider requests that you prepay the
full $600 in January. In a perfect world, if you were to cancel the contract with the company the
next morning, you would receive all the money back because the company has not yet provided the
service. In effect, you have simply given
the company an interest-free loan.
Therefore, if you were to cancel the
contract in three months, you would get
back $450 [$600 − ($50 per month × 3
months)]; if it were cancelled in six
months, you would get back $300: and
so on.
You have paid the $600 in advance but
the service provider owes you the service
which you will receive in the future.
As a result, this payment is considered
an asset (which is a prepaid expense).
There is no expense (i.e. a decrease in net
worth) until the service is provided.
As each month goes by, the value of the prepaid expense will decrease together with your net worth.
In other words, you are recognizing
the expense in the month in which it is used—not when it is
paid.
If you prepare your financial statement
each month, after the first month’s
service is provided, you will recog-
nize $50 as an expense for that month
(which decreases net worth) and the
remaining prepaid portion will be
$550 as shown in Figure 1.33.
An increase in expenses relates to a
decrease in net worth. Cash does not
have to be involved to increase an
expense and decrease net worth. You
will recognize $50 as an expense for
each of the next 11 months as the
supplier provides the service.
2
ASSETS
PERSONAL BALANCE SHEET
LIABILITIES
CASH
PREPAID EXPENSES
HOUSE
AUTOMOBILE
CONTENTS
OF HOME
UNPAID
ACCOUNTS
MORTGAGE
LOANS
NETWORTH
- $600
+ $600
+
+
CASH
PREPAID EXPENSES
-
-
INCREASE
INCREASE
DECREASE
DECREASE
600
600
No change in net worth
______________
FIGURE 1.32
2
ASSETS
PERSONAL BALANCE SHEET
LIABILITIES
CASH
PREPAID EXPENSES
HOUSE
AUTOMOBILE
CONTENTS
OFHOME
UNPAID
ACCOUNTS
MORTGAGE
LOANS
NETWORTH
$600
- 50
= $550
+
+
PREPAID EXPENSES
MAINTENANCE EXPENSE
-
-
INCREASE
INCREASE
DECREASE
DECREASE
50
$600
50
Opening
Balance
Net worth decreased by $50
______________
FIGURE 1.33
