Hello guys! Happy weekend.
How are you? And happy Maulid Nabi day in Indonesia on Monday!!
In this session, I want to share about accounting stuff. Of course, for you who learn about this know about cost and expense. To be honest, when I was in university, I always thought about it too. What is the differences of them? Well we are going to discuss it here!
Firstly, let's discuss about the component, when will we use them? In my opinion, cost is always relate with prepaid, for the example prepaid rent, prepaid insurance while expense is always relate with what always spend which will decrease the income like salaries expense, insurance expense, and etc. But when it comes to insurance, there's prepaid insurance and insurance expense which both of them will detract the income and cash. We spend our money for something right? So, what's the differences?
One of my lecturer always said that the differences of cost and expense like cost is the money we spent money on something, either for objects or services, that we have not feel the benefits of it, furthermore, and when we already feel it or use the object or services, it becomes expense. Simple right? Those definition had always been rooted in my mind until last week. When my boss in my office trained and asked us, me and my friends, about it. Automatically, I answered like that. So he asked again to me like this "if you said so, why don't you write cost in income statement but in asset? Why you write expense in income statement? But in other hand, the essence of cost and expense are same right? You spend your money. And why there is prepaid expense as an asset in financial statement not in income statement, instead you write expense rather than cost?"
In that position, if it was in a chess game, I felt like I already in skakmat position! LOL. He was ABSOLUTELY RIGHT!!! Maybe you guys already know the answer, so it was me who is fool here. LOL. And I thought fast, why we write cost like prepaid in asset which will influence the financial statement. Instead of cost, we write it expense like prepaid expense not prepaid cost? "WHY IT HAPPENED?" What is the decision whether the cash that we spend for cost or expense? What is the differences??? Curious? INDEED!!!! Here is the inference I made according to what was my boss said and some quick research I made.
First step is we have to classify between cost and expense. Actually, what my lecturer told me is not fault at all unless not too detail. It's okay if we classify something as cost if we are not feel the benefit of items or services we paid. In addition here, we also take advantage of the stuffs or services not only in a short term but also in a long term and it needs an adjustment if we already feel the benefit of something we paid. Moreover Cost is for asset. ASSET! Here, we will write cost if it is/will (be) used for operational purpose like land, buildings, machinery, equipment, vehicles and so on. If the building for a private house for the commissioner, it is not counted as cost.
Usually, if you see the financial statement, we categorize cost as prepaid or acquisition like acquisition cost whether in fixed assets or intangible assets. Later, if we already feel the benefits, it is appropriate if we make an adjustment that those cost will become and expense. We write prepaid expense rather than prepaid cost because those cost later will be used as our expense. Still confuse? Let's see the example.
Example: On 1st March 2016, A Company rent a building in Sunrise Street with a price Rp120.000.000 for 10 years which they already give the money after the company signed the contract. They would utilize it as their branch office. Here, firstly, we have identify, what we are looking for? We want to rend a building. It means it would be our fixed asset. Second, What is it for? For operational because it would be our branch office. Third, how long it will be used? 10 years. Long term utilization is identified. Are we already pay it? Yes because we already paid it after the contract so it becomes our prepaid expense or prepaid rent. Are we already feel the benefit? No, because we paid first and after we utilize it, we will admit the cost to be an expense. Even if we rent it, we will utilized it for our operational activity and we already paid it in cash even though we are not use it yet! So the journal is Prepaid rent Rp120.000.000 (Db) and Cash Rp120.000.000(Cr). We divert money we have as an asset. The money is reduced but diverted into assets in the form of prepayments a.k.a prepaid rent.
As I said before, if we already feel the advantage of/use the building, said on 31 December 2016, it means that we should adjust the cost to expense. So the journal will be Rent Expense Rp9.000.000 (Db) and Prepaid Rent Rp7.000.000 (Cr). We have to calculate it with straight-line method to adjust the usage of prepaid cost which is in this case is Rp120.000.000 : 10 years = Rp 12.000.000/year. So, the expense for a month would be Rp12.000.000 : 12 months = Rp1.000.000/month. We already used it for 7 months, 1 March 2016 - 31 December 2016. So Rp1.000.000 x 9 = Rp7.000.000. How about for fixed asset that we wrote it as acquisition cost, it's not clustered as prepaid expense, how will we make it to expense? Well, we will make it to expense through depreciation.
Perhaps, it sounds simple on a rent case especially for fixed assets. How about insurance? You make a payment first towards the assets such as machine that in the end, you will feel the benefits from the insurance service started in a certain time for every month. How about insurance towards employee? I ever thought 'what is the benefit of us do an insurance for the worker if in the end, the money we save will be given towards another parties (worker)? Which it wouldn't give any benefit to add our equity." After a long discussion with a friend of mine, I made my own summarize that we also feel the the service of our employees towards our company which the increasing of equity is not always measured with money but also a service. Likewise, if I'm not mistaken, the company will cut staff salaries, some percents, that will be used for their insurance. The point of the insurance is still the same, we pay first nevertheless utilization are deducted in the next period. How about the salary that we pay first? It's also included as prepaid salary. If the worker is already work in a certain time, we only need to make an adjustment again. Expense Salary (Db) and Prepaid Expense (Cr).
Another important thing you should remember is also to see the policy of the entity, which approach they implement there? Balance sheet approach or income statement account approach? If they use balance sheet approach, the example I given above is appropriate. However, if they use income statement account, it's quite different. Even if you pay without having any benefit, you still already admit it as your expense. Then a company should consistent against the implementation of method, so the Statement of Financial Position will relevant.
The example of Income Statement Account. On 1st June 2016, A Company pay the insurance premium in cash for 12 months Rp12,000,000, so the journal you made is Insurance Expense (Db) Rp12.000.000 and Cash (Cr) Rp12.000.000. Despite of you already feel the benefit or not, as long as you already take off your many from cash, you already grant it as your expense, On 31 December 2016, you want to make an adjustment, so it will be, Prepaid Insurance (Db) Rp5.000.000 and Expense Insurance Rp5.000.000. Expense insurance that you admit is only Rp7.000.000 (1 June-31 December), so the form of income statement is able to report that the real insurance expense is Rp7.000.000 with an adjustment of insurance expense on credit side Rp5.000.000.
All in all, if you do an audit in every company, you have to make sure first, what is their approach method to the recognition of prepaid expenses so you are able to determine where you have to admit a money company spent as cost or expense. Balance Sheet Approach or income statement account approach? the Balance Sheet Approach admit cost as prepaid expense as long as the company does not feel the benefit of things or services they paid off. If you already feel the advantage of something you paid, then you admit it as expense. Reversely, Meanwhile Income Statement Account Approach acknowledge money you spent on cash without any hesitation if you already use the things or services you paid or not. In a time they already feel the advantage, they just adjust the insurance expense in credit with a residue value of expense that the company do not feel the benefit of the money they spent. Don't forget to identify first the useful of it (questions in bold mode). It must be for operational purpose.
This is only a simple summarize of what I understood. Some flaws might be there, so if you have questions or other opinion, please comment it below. I will accept and try to response it soon. Thank you!
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