Question

Should prepaid assets make difference in ROA calculation? (8 points)

Some costs are post paid, therefore, it creates liabilities. For example, salary is post-paid, meaning that the employees will get paid after they provide services. In class, we find that operating liabilities such as salary payable should be excluded in the denominator for ROA to be consistent with the idea.

Some costs are pre-paid. Rent (if paid in advance) and insurance come as a good example. Inventory is also pre-paid. Keep in mind, though, ‘pre-paid’ doesn’t always means that the company has to pay upfront. It is pre-paid because company has to pay upfront or acquire first in exchange for liabilities.

For example, let’s say we have an insurance contract, which is pre-paid in nature; annual contract for $2,400. Normally, we can pay $2,400 upfront.

In the examples below, company A paid $2,400 in advance. Company B thinks the pre-paid nature is unfair, so it was able to negotiate a deal with insurance company, so that it can post-pay after each month. Thus Company B acquires same insurance, but its insurance pay schedule is following.

• Company B gets coverage of insurance for a year starting from 5/1/2016. (same coverage as Company A’s insurance)
• For the month of May, monthly insurance is $200 (2,400/12).
• The $200 Bill for the May arrives June. On May 31, Company B should record coverage of insurance by recording insurance expense.
• Annual contract will be voided if company B skips payment even once.

Table 1. Background information and Balance Sheet of company A and B.

	Company A	Company B
# workers	8	8
Daily salary / employee	$100	100
Daily Sales revenue (all cash)	$1,100	$1,100

Beginning, 5/1/2016	Company A	Company B
Assets (all cash)
Cash	$50,000	$50,000
Equipment	60,000	60,000
Less : Accumulated depreciation	(15,000)	(15,000)
Total Assets	95,000	95,000
Liability	0	0
Note payable	60,000	60,000
Equity (common stock)	35,000	35,000
Insurance policy (all purchased insurance on 5/1, coverage starts from 5/1/2016 to 4/30/2017)	Purchase insurance 1 year ($2,400) in advance, paid cash on 5/1/2016	Annual contract started on 5/1 Structured a deal that insurance is post paid

Additional Info

1. May 2016 has 23 working days. All the salary was paid during May 2016.
2. Company B will pay $200 in June 2016 for the insurance provided in May 2016. Therefore, as of 5/31, the $200 is a liability (use insurance payable for this)
3. Equipment was purchased on 5/1/2015, for $60,000 (issued debt, note payable). No salvage value and its useful life is 4 years.
4. Note payable commands the annual interest of 3% (due 5/1/2021). Interest is payable in every year 4/30.
5. Both companies, A and B, paid dividend of $2,000 on 5/30/2016.

Q1. Provide journal entries for company A and B related to insurance, if any. Remember, only post paid account has designated payable account (Interest is post paid -> Interest payable. If account is prepaid, we charge to accounts payable.)

Q2. Complete the Balance Sheets right after the insurance purchase for company A and B. Explain the changed numbers (between before and after purchase of insurance)

As of 5/1/2016 (after insurance is purchased)	Company A	Company B
Assets
Cash
Equipment	60,000	60,000
Less: Accumulated Depreciation	(15,000)	(15,000)
Prepaid Insurance
Total Assets
Liabilities
Note payable	60,000	60,000
Total Liabilities
Equities (common stock)
Total Liabilities & Equities

* Fill it using the answer to Q1.

Answer 1

1. Company A

Date	General Journal	Debit	Credit
5/1/2016	Prepaid insurance	2400
	Cash		2400
	(To record insurance purchased in advance)
5/31/2016	Insurance expense	200
	Prepaid insurance		200
	(To record expired insurance)

Company B

Date	General Journal	Debit	Credit
5/1/2016	No entry
5/31/2016	Insurance expense	200
	Insurance payable		200
	(To record insurance payable)
June 2016	Insurance payable	200
	Cash		200
	(To record insurance paid)

2.

As of 5/1/2016 (after insurance is purchased)	Company A	Company B
Assets
Cash	47600	50000
Equipment	60000	60000
Less: Accumulated depreciation	-15000	-15000
Prepaid insurance	2400	0
Total assets	95000	95000
Liabilities
Note payable	60000	60000
Total liabilities	60000	60000
Equities (common stock)	35000	35000
Total liabilities & equities	95000	95000

For Company A, on 5/1/2016 the cash account will decrease by $2400 for the amount paid for purchase of insurance and prepaid insurance will increase by the same amount. However, for Company B, there will be no change on 5/1/2016 since the insurance payable will be recorded on 5/31/2016 and same will be paid only in June.