Prepayments, concepts and accounting

So today’s question is, how to handle prepaid transactions in accounting & bookkeeping. There are below important points in handling prepayments:

First of all, you need to ‘identify’ a prepaid transaction. A prepaid transaction occurs when you have made the payment, but you have not received goods and services in consideration of that payment. Alternatively, you’ll be delivered those goods or services over a while and not instantly upon payment.

A prepaid expense is represented under current assets in the balance sheet. Once the prepaid cost is utilized, it is presented as an expense in the income statement.



General examples of prepaid expenses

Following are some generic examples of prepaid expenses:

Rent paid in advance:

Usually, office and building rentals are paid by businesses in advance for three months or six months or sometimes for one year. So, let’s say if you have spent six months’ rent on 1 January for the period from 1 January to 30 June, you need to record this transaction as a prepaid expense on 1 January. Then, at the end of each month, you need to classify one month’s rent as an expense and reduce your prepaid rent gradually. Thus you’ll be passing debit rent expense and credit prepaid rent account entry at the end of every month.

Medical Insurance paid in advance:

Medical insurance for the employees and their dependents are usually paid for one year in advance (or at the beginning of the insurance period). Therefore, at the beginning of the insurance period, the insurance premium paid should be recorded as a prepaid expense and then it should be amortized subsequently at the end of each month as an expense. Same is true for any property or liability insurance.

Subscriptions paid:

If your organization is a member of any trade association or an activity group and you pay annual subscription of that association in advance at the beginning of each year, then, this annual subscription would be considered as a prepayment for one year when paid at the beginning of the year. You need to amortize this payment every month into expenses and gradually reduce the prepayment account.

Prepayments for goods or services:

If a supplier requires to make a prepayment (or advance) for before they can deliver products or services to you, then, this payment of advance to the supplier would be classified as prepayment until goods or services are provided.

Training program:

If a training program of six months is purchased and payment is made in advance, then this advance payment should be booked as a prepaid expense in the balance sheet. This prepayment will be expensed out every month in profit and loss.

Software fee:

If you have purchased a license for a software for one year (or less), then you can book this amount as a prepaid and charge it out to P&L every month.

Trade license:

In certain countries, a trade license is issued at a high cost for a year. This trade license cost should be recorded as prepaid and then monthly expensed out.



One comprehensive example of prepayment

For example, if you have to place an order for delivery of 500,000 blocks for your next construction project and the supplier of construction material provider has asked for an advance payment of 25% of the value of the order before he can accept the order. Now, let’s say today is 28th of the month, and you place this order with advance payment of (say) $1,000. You make the payment, and now you want to record this transaction. The delivery of the blocks will come after 15 days, i.e., in the next month and you need to close your books of accounts, and you also need to record this transaction of payment of $1,000.

Above is an example of prepayment transaction where you have made the payment but you didn’t receive any item regarding the payment, yet. So, you’ll record the transaction as follows:

Debit: Advances to suppliers account (a type of prepaid accounts) $1,000

Credit: Bank account $1,000

The ‘advances to suppliers’ account is a general account for any supplier to whom advance is given. This account is one example of prepaid accounts. If you don’t have an advances to suppliers account, you can use a general ‘prepaid expenses account’ also. However, the important thing is, this payment should be classified as a debit amount in the month-end financial statements.

Now, when the construction blocks are received in the next month, you need to record the transaction of receiving blocks. The accounting entry would be as follows:

Debit: Construction material account $1,000

Credit: Supplier payable account $1,000

Now, with the above entry, the receiving of the material is recorded. However, currently, we have a payable to supplier account and a receivable from supplier account (in advances to supplier account). Now, we need to knock-off these two accounting entries to clear the prepayment.

Now, we’ll pass below entry:

Debit: Supplier payable account $1,000

Credit: Advances to supplier account $1,000

This above accounting entry will nullify our prepayment, and thus we’ll have nil balance in our prepayment account.

A short way could have been to credit advances to supplier account debiting material account directly. However, in that case, we would not find any entry in the supplier’s account if we needed to check at a later stage whether we had any transaction or payment to this supplier.

The above was a comprehensive example of one prepayment.


Further important points

It is essential to understand why we have to book payments are prepayments and then reverse these payments later at the time of delivery of goods and services. This accounting treatment is to ensure that we present our financial assets and liabilities correctly in our financial statements. If we have only made the payment and have not received the service, then this payment is an advance and should be classified as a current asset in our balance sheet. However, if we have received requested goods and services, then those payments are expenses (or sometimes assets) and therefore, should be correctly classified.

Sometimes, people get confused about advances and prepayments. All advances are not prepayments. For example, advances paid to staff for their personal needs are not prepayments. So, the rule is, if advance paid will be returned to the business, then it is a simple advance and not a prepayment. However, if the advance paid will not be refunded, instead, some goods will be delivered, or service will be performed, then that advance is a prepayment.

It is essential to differentiate prepayments from securities and deposits. Securities are payments made as a guarantee or collateral; it is a safety for the other party ensuring compliance with the contractual obligations. Deposits are money kept with suppliers’ accounts which are usually returned at the end of the contract period or after a fixed period. We do not amortize securities and deposits, as we do with the prepayments.

Accounting for prepayments can be complicated sometimes. You need to prepare a prepayment schedule to keep a record of all the prepayments. Sometimes, annual payments are made in the middle of the year such that payment partially relates to past and future months.  In such cases, ideally, you might have accrued expenses for which payment is made in the middle of the year. Please read our articles on preparing prepayments schedule and accruals accounting for details on handling such complex scenarios.

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