Prepayment accounting, also known as prepaid expenses, is the accounting method used to jolt down the payments in the books of a company when the company pays for products or services before it receives the product.
Sometimes, what happens is that companies have to pay before they receive the product, which does not happen usually. It could be because the seller is not willing to extend credit to the buyer, or the seller will provide some reward such as a discount on the purchase, or there could be many other reasons for why payments are made before the product or service is received.
Now, for buyer and seller, how the prepayment transaction is recorded would be different. For buyers, there would be two accounts. A prepaid account and a cash account. In the books of the buyer, the prepaid account would be debit with the amount equal to the amount of the purchase, whereas the cash account would be credited with the same amount of money as the prepaid account.
For the seller, the opposite would happen. As the seller would have received payments, the prepaid would be credited, whereas the cash account would be debited, with the amount equal to the purchase amount.
Consider, renting, renting is a prepaid payment. You not only have to pay for the rent before every month, you also have to pay a security deposit. Now, take a person, Phil, who moves into a new apartment, the rent per month is fifteen hundred dollars, and the security deposit is nine thousand dollars. Phil deposits both the first month and the security deposit.
For Phil, the prepaid account would be debited with ten thousand dollars, and the cash account would be credited with the ten thousand dollars. For the landlord, the payment would be credited with ten thousand dollars in the prepaid account, and the cash account would be debited with the same account.
Table 1: The accounts books of the landlord
The accounting measurement for prepayments is very simple. In the start, there is no impact on the balance sheets of the company. The cash accounts and prepaid accounts are credited and debited with are considered assets.
The changes happen only when there is an adjustment. Take the example of rent stated above. The payment would not be recorded as an expense until the next month.
The prepayment is only recognized in the balance sheets of both the buyer and seller or the renter and landlord after a certain amount of time has passed. For renting, this happens after every month. The expenses are recognized in the balance sheet of the renter, the cash transfers are also recognized as payments after a month in the books of the landlord. So, the recognition usually happens after only a month.
Journal Entries for prepayments
The journal entries occur on the asset side of the balance sheet for both the buyer and seller. The recognition usually happens after one month, when payments and expenses are recognized by the seller and buyer, respectively.
The cash account of the seller is debited, while the prepayment account is credit for an amount equal to the amount paid by the buyer. This is shown in Table 1. For the buyer, the opposite happens. During the journal entries in the accounting book of the buyer, the prepayment account is debited with the payment, whereas the cash account is credited, both accounts with an amount equal to the amount paid by the purchaser.
Classification of Prepayment
The classification of prepayment is shown in figure 1. There are three main types of classification, based on the reason for prepayment. These three are corporate, individual, and tax-related reasons.
Figure 1: Classification of prepayments
The classifications are discussed in detail below:
The corporations prepay for a number of reasons. Sometimes, they pay before because the supplier has a special deal which would offer a discount on the purchase. By paying yearly, the company can save money. Corporations also pay beforehand for the leases. The lease for land is usually paid a full year ahead.
Companies that are involved in manufacturing also prepay for electricity. This helps ensures a good supply of electricity without any interruptions. Because any blackout would cause the machines to stop working which could result in huge losses as manufacturing of the company’s products stops.
Corporations may also prepay for supplies before the busy season just to make sure that they receive their products on time.
There are only two types of prepaid expenses associated with individuals. Those two are rent payments and prepaid insurance.
The rent has to be paid before the month starts. The security deposit also has to be made. The payment for the rent is made beforehand. Similarly, the insurances are also prepaid. Health and life insurances have premiums.
These premiums are paid beforehand. An individual does not pay for health insurance after he/ she is sick or for life insurance after he/ she is dead. The insurance has to be paid beforehand. Before the event occurs for which the insurance is covering.
Tax related reasons
There are many benefits to paying tax beforehand. Many corporations pay tax beforehand to reduce their tax bills. When tax bills are paid before the due date, the corporations receive tax rebates from the Government.
Companies also deduct taxes from the salaries of employees and pay the taxes for employees. There are two advantages of this. One is the Tax deducted at source or TDS, where the taxes are deducted at source and second is the tax benefits that the Government provides to the corporations for helping with the payments of taxes on the behalf of its employees.
Frequently asked questions
Is prepayment a current asset?
Yes, prepayment is a current asset. This is due to the fact that prepayments are usually paid for invoices or bills which are due within a month. And as we know from the definition of current assets, these are the assets that can be liquidated within a month to pay for any unforeseen circumstances.
All of the prepayments are current assets. But, the leases may or may not be considered a current asset. This depends upon whether a lease is yearlong or more. Sometimes, even leases that are more than a year can also be classified as a current asset. This would depend upon whether the company can liquidate the lease within a year or not.
Where do prepayments go in the balance sheet?
The prepayments are classified as assets in the balance sheet of a company. Furthermore, the prepayments are classified as current assets. This means that the prepayments are highly liquidating assets. This is due to the reason that usual prepayments are made one to three months before the product or service is received.
Leases are the ones that are the assets for which prepayments are made way beforehand. The usual prepayment date for the balance sheet is usually a year. Some leases last longer, but these also go into the assets side of the balance sheet.
What are the examples of prepayments?
The most common example of prepayment is the rent payment. The rent is always paid before, and not after. The security deposit is also paid before, and not after the person has stopped living there. The rent is always paid before the month starts. So, it is an example of prepayments.
Another example is the lease agreement. The lease is paid for a full year ahead, and not a month ahead like rents. So, the lease agreements are a longer form of renting, but both are noted as prepayments in the balance sheet.