Like accruals, prepayments are an application of the accruals concept, as they are types of adjustments that made to ensure that the effect of transactions are recorded in the correct accounting periods.
Prepayments are recorded when an invoice/receipt is issued before an accounting period-end but the associated goods or services are provided after the period-end.
Let’s illustrate the need for prepayments using a business with a year-end of 30th June 2020. On 1st January 2020 it paid £2,000 for insurance cover from January to December 2020. This cost will be recorded in full in the business’ Cash Book for the year ended 30th June 2020 but half of the cost relates to insurance cover to be received in the next accounting year; i.e. 30th June 2021. A prepayment must therefore be recorded to ensure that the cost of insurance is shared between the two accounting years.
Types of prepayment
As was the case with accruals, there are two types of prepayments; prepaid expenses and prepaid income.
A prepaid expense occurs when an invoice is received or a payment is made before the period-end but some or all of the associated goods or services are received by the business after the year-end.
|Rent||Rent of land buildings is often paid in advance of the rental period|
|Insurance||Insurance is typically paid in advance of receiving the insurance cover|
|Car tax||Businesses often pay for their landlines on a quarterly basis|
|Advertising||Advertising is often invoiced in advance|
Prepaid income occurs when a business invoices a customer (or received payment from a customer) before the accounting period-end but provides the goods or services after the accounting period-end.
A landlord for example, may invoice their tenants in advance and at an accounting period-end will have to identify any rent that has been charged for but has not been provided to the tenant by the period-end.
Determining the value of a prepayment
The calculation of the amount of a prepayment is very similar to calculation of an accrual and often involves apportioning an amount on the basis of time.
To illustrate this, let’s say we have a business with a year-end of 31 December 2019. During the year, it paid £4,500 plus VAT for advertising in the July 2019 to March 2020 editions of a popular magazine. At the year-end it will consider how much of the net payment of £4,500 relates to the year in which the payment was paid and how much relates to the next year.
The advertising covers nine months, of which six fall in the year-ended 31 December 2019 and three in the year-ended 31 December 2020. As such, £1,500 (3/9 x £4,500) will be recorded as a prepaid expense when the accounts for the year ended 31 December 2019 are prepared.
Recording an prepayment
When recording a prepayment we will:
- Reduce the expense or income for the year
- Record an liability (when a prepaid expense is being recorded) or an asset (when prepaid income is being recorded)
We will look at the this is detail over the next two pages.