Fundamentals of Financial Statements

¶ … Financial Statements

ATTN: Aunt Cookie

Re: Specific Financial Statement Questions

With regard to the questions you raised about your financial statements for last year and the current year (about prepaid rent, interest on notes payable, cash advances as revenue, and how owner equity is affected by each of these items), I have prepared explanations for each topic below.

A) Prepaid rent is shown as a cash asset because the early payment creates an increase in the firm's property. It does this by guaranteeing an expense is paid for early, decreasing the firm's expenses for future months and in doing so increasing property owned (the

rent). It also reduces the rent column by the same amount as cash is reduced by, since both are being decreased by the payment. This transaction does not affect liabilities, since it is not incurring debt, and also does not affect equity, since the asset increased is property owned (the paid rent) and not a capital asset. In December, when the prepaid rent is utilized for the month's rent expense, it will be deducted from the company's asset of prepaid rent and deducted from the expense of rent for an equal amount.

B) Regarding the $10,000 bank note: Interest for the entire note is listed as an expense incurred for the period in which the note was taken out, not the period in which it is due.

As such, the interest for the note is listed, whether paid or not, during the period in which

it was incurred -- in this case, December of this year. It is listed as a liability and not an expense, since it is a debt note for future payment and not immediately due, the way an expense (for example, employee wages) would be.