Prepayments in accounting can be complicated to grasp. We have, therefore put together a full description and examples to show you how it works. The information is suitable for both businesses and students.
Prepayments are needed in businesses to account for the correct figures in a financial period.
If you are using cash basis for the accounting prepayments are not required. The cash is accounted for when it leaves the bank. Most businesses use the accruals method and account for items when they occur.
Our simple prepayment calculator at the end of this article will help to calculate a prepayment.
What are Prepayments in Accounting
Prepayments are when a business pays for certain expenses in advance, but the benefit is received in a later period. By adjusting the accounts, it ensures that the figures are correct for the financial period.
An excellent example of a prepayment is insurance. A business might purchase a whole years insurance but only needs to account for a few months. We will use this in an example below.
The financial period maybe a month if the business creates regular reporting or for the financial year.
There are several reasons a business creates a prepayment, including:
- Paying for goods or services in advance
- Trying to fix a price for something, therefore paid early
- Deposit for rental
Prepayments in the Balance Sheet
A prepayment is shown in the balance sheet as a current asset. The balance sheet example below shows the prepayment.
When the expense is incurred, it will transfer from the balance sheet to an expense in the Profit and Loss account.
Prepayments Double Entry
If you are creating a prepayment in the accounts, there will always be two entries that balance each other. It is double entry accounting.
In our examples, the original businesses transaction is posted to an expense in the profit and loss. It is also possible to post directly to the prepayment in the balance sheet.
To create the journal, the transactions required are credit the expense account and debit the prepayments. In future periods it will be reversed to account for expense in the correct period. There are options in accounting software for the journal to reverse in the next period automatically.
In accounting software, it is possible to set up a recurring journal for each month, which will save having to create it each time. The image below shows setting up a repeating journal in Xero.
Insurance Prepayment Example
A business pays for a whole years insurance of 1200.00 so that it doesn’t pay interest on the credit.
The financial year runs from January to December, and the payment is made in September.
In the first year, only four months are accounted for in the profit and loss account. A journal is created for the remaining eight months to transfer to the prepayments in the balance sheet.
The payment transactions are:
|Bank (Balance Sheet)||1200.00|
The prepyments journal is as follows:
|Prepayments (Balance Sheet)||800.00|
It reduces the insurance in the Profit and Loss account to 400.00 in the first year.
Rent Prepayment Example
A business signs a contract for renting a new office. The agreement requires that the whole year’s rent is paid in advance. The rent is for 500.00 per month. The rent of 6000.00 is paid in advance.
The rent is from March to February, and the accounting period is from April to March. Therefore 11 months rent will post to the first year and one month to prepayments.
The transactions are as follows:
|Bank (Balance Sheet)||6000.00|
The year-end journal is:
|Prepayment (Balance Sheet)||500.00|
Use our simple prepayment calculator to work out how much prepayment to enter to the accounts.
Enter the amount of the original transaction and the amount in months that relate to the current period.
Using the example above for insurance, the figures are as follows:
You can now add your figures into the calculator below:
Prepayments in Accounting – Summary
Prepayments in accounting are payments that are made in advance of the goods or services provided.
A prepayment journal will adjust the accounts to reflect the amount for the accounting period.
Further reading on prepayments is available on Investopedia.
Return from prepayments in accounting to balance sheet page.