We operate in a fiscal year, July - June. The auditor says if we have signed a commitment in July to pay (annual worker's comp insurance for example) $500,000 over 9 months for the year, we are supposed to record the $500K liability against prepaids. The prepaid basis of $500,000 is amortized by the general ledger account over 12 months while the accounts payable dept. relieves the liability over 9 months. Make sense? My boss never heard of this concept but I explained that this was an audit finding in my previous employment elsewhere.

Thanks! Jackie

I have copied the definitions for you from IAS 37, which will be helpful:

A liability is a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits.

An obligating event is an event that creates a legal or constructive obligation that results in an entity having no realistic alternative to settling that obligation.

A legal obligation is an obligation that derives from:
(a) a contract (through its explicit or implicit terms);
(b) legislation; or
(c) other operation of law.

A constructive obligation is an obligation that derives from an entity's actions where:
(a) by an established pattern of past practice, published policies or a sufficiently specific current statement, the entity has indicated to other parties that it will accept certain responsibilities; and
(b) as a result, the entity has created a valid expectation on the part of those other parties that it will discharge those responsibilities.

Your question does not mention the exact period for which the company is liable for the payment of workers compensation insurance. I presume that since the auditors have mentioned it in July, it must therefore be for the previous year. As such this is a liability for the previous year which is to be settled over a period of nine months of the current year.

I am not sure about the prepaid mentioned by you, which does not make sense.

Some day you'll get that the average person doesn't understand a word that stuff is saying. It's not in English - it's a combination of legal-ese, literature-ese, and jibberish-ese, of all which most people don't understand. Even accountants get confused when new statements come out, trying to interpret them and apply them. So why would you expect non-accountants, or worse students, to understand them? Remember these are learned with benefit of textbook, instructors, examples and practice, not by just simply reading them and suddenly understanding everything. (Otherwise, why take classes?)

Here's the important part: If you had an event and owe for it, then you have a liability. In this instance, did you get coverage under workers comp already and therefore now owe for it? This is not saying what date the bill is "due" - this means you do have the obligation to pay for it, for the coverage that you already got, if you already got it.

So the question all relies on if they already provided the coverage. It really doesn't have a whole lot to do with when exactly you've agreed to make the payments. Now I'm just using your workers comp thing as an example, since you did. (Are you really talking about workers comp? Cause in this state, it's always paid six months up front, so it would be a prepaid and wouldn't fit your example.) But, if they were providing the coverage, you would have the expense as they provided it.

Since you haven't said what this actually is and only used workers comp as an example, you could be referring to something that could be some kind of exception for this. But forgetting exceptions... I disagree with the concept of putting something into a prepaid and into a liability at the same time. A contract in and of itself does not constitute an economic event, so I don't care about that.

A prepaid is a deferral. This means you've paid up front for something that has not been provided to you yet. In the case of workers comp, coverage would be the "thing" provided. So this would be like you paying up front and then the coverage coming to you in the future. Money first, expense second.

A liability is an accrual. This means the event has already happened, you have already been provided with the benefit. i.e. you've already been covered in the past. But you have not paid it yet. Expense first, money second.

A prepaid and liability existing together is a little bit of an oxymoron. And you haven't paid anything, so where's the prepaid coming from? It doesn't exist. Rehmanvohra also said the prepaid did not make sense. Also note his assumption that the coverage had already been provided as of that date -- and that assumption is coming from this liability - that you have the liability because the coverage is already provided and you haven't paid it yet. (That's because that's where liabilities come from.)

When the event happens, when the coverage happens, when the service gets provided to you - that's when you expense it. If you paid it prior to that time, then you have a prepaid, paid up front. If you pay after that time, you have a payable, paid after the fact. How do these exist together? How can you still owe something you paid up front??

So I disagree. How you should record it I do not know, because I don't know if you've already incurred the expense. It sounds like not. It sounds like the prepaid is being used because you haven't actually incurred the expense yet, and that it's going to be expensed over 12 months. But you also haven't paid it yet, and that the payments will be in the future. If that's true, I don't think anything should be recorded at all. However, you do have an issue that the payments are over 9 months but the contract is over 12. So those don't match. You'll be paying it faster than you'll be getting the benefit. (That's not as hard as it sounds.)

You are not required to have your interim (monthly/quarterly) statements correct. That would be a management decision how correct they want these to be, not really an auditor's decision. (Though 'management decision' can be to let the auditor say.) So first of all, how important is it that you have each month totally correct? Cause the easy way would be to put it into the prepaid as you make payments, and then at the end of your fiscal year figure out how much should be expensed. (You're paying faster than expensing, if my interpretation of this is correct.) If it's really on the same 12 months as your fiscal year, you could just expense it as you pay cause the year-end (the important one) would be correct. If someone wants the monthly statements correct on this point, you'll have to figure out the 9/12 month conflict and get the right amounts recorded each month. (If you want help on figuring that out, just ask.)

It does occur to me... Sometimes we have to do weird things due to software. Software does not always allow us to do things the way we'd like, so we have to do some cheating.

One of the problems that can arise is having a bill in hand and wanting to get it entered into the computer, into the vendor account. To do that we have to do something with it. Most bills we get are for expenses already incurred. But what if the bill is for something that hasn't occurred yet - where does it go when we enter it into the computer?

Well, the prepaid is one solution. It's cheating, to solve a software issue. So it goes into the payable with a credit, and instead of into an expense as debit, it goes into the prepaid instead. Theoretically those shouldn't happen together.

However, when we have to cheat like that (which happens often actually), then we also must make adjusting entries at year-end to be sure all expense, prepaid and liability accounts are in the proper amounts for the sake of the financial statements. Like a case like this, you'd want to make an adjusting entry to get the prepaid and liability accounts out of there, and then they can be reversed at the start of the new year to put it back where it was. (The adjusting entry won't remove it from the vendor account.)

I don't know if that makes sense. For someone who actually does this on a regular basis and also makes adjusting entries, it's really not that uncommon.

Is it possible this is the only reason the auditor on that last job said to do it this way? If that's the case, it only meant it was a way to cheat the software, and not because that's the way the rules work.