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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 doesnt 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, lets 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 As 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.

Q5. (1 point) Calculate ROA for company A and B. Show your calculation for Average assets.

For ROA, first use conventional version, namely,

	Company A	Company B
EBI (NI + Int exp, AT)
NI
Interest Expense, AT
EBI
Average Assets
ROA

Q6. (1 point) Analyze the three companies financial and evaluate company Bs decision to structure the insurance deal into post-paid, in the perspective of ROA. Also answer the following:

Q7. (1 point) Should the prepaid assets such as prepaid insurance be excluded in the denominator of ROA? (Hint : Answer is no.) Explain your answer.

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