Prepayments are common for companies that may prepay suppliers or other parties for a promise of future goods or services. Therefore, companies must follow the accounting guidelines for prepayments. However, it is crucial to define what they are first.
What is a Prepayment?
A prepayment is an advance payment made for goods or services before they are received. In accounting, prepayments are recorded as assets on the balance sheet until the associated service or benefit is consumed. This practice helps manage cash flow and can result in favourable terms or discounts. Prepayments can appear on the balance sheet under several names.
Once the goods or services are received, the prepayment gets converted into an expense. For instance, if a company pays for a year’s insurance upfront, the amount is initially listed as a prepaid expense. As time passes, a portion of the prepaid amount is shifted to an expense account to reflect the insurance cost accurately for each period.
What is the accounting for Prepayment?
When a company pays for goods or services in advance, it cannot recognize it as an expense. It is due to the matching principle that requires matching expenses to the revenues they help generate. However, the company must account for the transaction. Therefore, it must be recognized as an asset on the balance sheet. In most cases, the classification falls under the current assets header.
Once the company receives the goods or services, it can recognize the expense. At this stage, it must remove the balance in the prepayment account and take it to the income statement. In cases where the company does not receive any goods or services in exchange and receives the payment back, it must move the prepayment balance to the cash account.
What is the journal entry for Prepayment?
The journal entry for prepayments is straightforward. As mentioned above, it occurs in two stages. First, when a company pays for goods or services in advance, it must recognize an asset. The journal entry for this stage is below.
| Dr | Prepayment |
| Cr | Cash or bank |
Once the delivery of the goods or services occurs, the company can expense out the balance. The journal entry for this stage is as follows.
| Dr | Expense |
| Cr | Prepayment |
Example
Blue Co. is a service company that does home renovations. The company regularly pays its suppliers in advance to receive goods. During one project, Blue Co. paid its wood supplier $3,000. The company recorded the transaction as follows.
| Dr | Prepayment | $3,000 |
| Cr | Bank | $3,000 |
After a month, the supplier delivered the goods. Blue Co. recorded the receipt as follows.
| Dr | Expense | $3,000 |
| Cr | Prepayment | $3,000 |
Conclusion
Prepayments are advance payments for goods and services. These are common transactions for many companies. In accounting, companies must follow the matching principle when recording them. Therefore, a company that pays a supplier in advance must record the prepayment as an asset. Once the delivery of goods or services occurs, the company can expense out the prepayment recorded earlier.
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