In many situations, firms pay for goods and services in advance. Insurance is a good example. Quite often, firms make full payment at the inception of a policy’s term. The accounting issue involves the proper treatment of assets and expenses. At the beginning of a policy’s term, an asset has been acquired: the right to be covered by insurance for the next year (or other time period). As the policy’s term progresses, the asset is used up and an expense is incurred.
Prepaid expenses are recorded at their historical cost. Because prepaids usually have a short life, their cost corresponds closely to market value, and few analysts would object to this valuation practice.
Prepaid expenses generally constitute a very small proportion of a firm’s assets. For example, in 1997, OB’s prepaid expenses comprised less than 1% of its assets. Consequently, prepaids are not subjected to extensive analysis. Recall, however, that they are included in the numerator of the current ratio. Because prepaids will be utilized in the near future, most analysts feel that this is proper. Note that prepaids are not a source of future cash inflows, but they do reflect the reduced need for future cash outflows.