When a prepaid income adjustment is required we will move income out of the current accounting period into the next one. This will be achieved by reducing a business’ sales (or another type of income such as rents charged) and creating a liability at the end of the accounting period. Then at the start of the next period we will reverse this prepayment.
There are two ways to record a prepaid expense in the General Ledger:
- By using a separate Prepayments account
- Without using a separate Prepayments account
We will illustrate how both methods work using the scenario below:
A business has an accounting year-end 31st December. The business rents a property it owns and bills its tenant quarter in advance (i.e. the tenant is expected to pay rent at the start of each quarter).
On 1st December 2019 the business received £4,500 from its tenant to cover three months’ rent from 1st December 2019 to 28th February 2020. As two out of three months fall after the year-end of 31st December, two thirds of the amount received (£4,500 x 2/3; i.e. £3,000) should be treated as being prepaid.
Recording prepaid income using a separate prepayments account
We will first record a journal to reduce the income for the earlier year and at the same time record a liability (as the business has an obligation to provide the goods or services after the year-end).
The following journal will be recorded.
The journal can then be posted to the General Ledger accounts (see below). The journal postings are recorded in blue and the rents up to the end of November 2019 in the Rents Received account are shown in black.
Once the year-end prepayment is posted we can close the accounts down. The prepayments account balance represents a liability as the business is obliged to provide the tenant with the use of the property in January and February. The balance on this account will be carried down to the start of the next period. The rents received account however, is an income account and its balance will be sent to the Profit & Loss account using the following journal.
The above journal will be posted into the General Ledger and the two accounts can be closed down for the year.
At the start of the new accounting period
At the start of the next accounting period (in this example, on 1st January 2020), we will bring the balance down on the prepayments account and then reverse the prepayments journal. This will have the effect of cancelling the liability and increasing the rental income for this period by the amount that was prepaid in the previous accounting period.
The journal will be posted to the General ledger as shown below.
If we now look at the Rents Received account there is a balance of £3,000 representing the rental income for January and February 2020.
Recording a prepaid income without using a separate prepayments account
Prepaid income can also be recorded without using a prepayments account. Where this is done, the year-end prepayment will simply be recorded as a balance to be carried down on the debit side of the expense account which will then be brought down on the credit side of the account at the start of the next period (see below).