Prepayments Occur When Payments Are In Advance

Today’s accounting tutorial will look at prepayments, which occur when an expense or income is paid or received before contract obligations are fulfilled. This tutorial will be looking at the prepayment of expenses rather than the receipt of income. We have another tutorial looking at the receipt of income in advance, and you can find that here.

This tutorial forms part of our series looking at balance day adjustments, including accrued revenue, unearned revenue and accrued expenses.

Definition of Prepayments

An expense is considered to have been prepaid when at the end of the reporting period, let’s say year-end, payments have been made for which the benefits have yet to be delivered by the third party.

These benefits might be in the form of a service, for example, insurance. Or it might be in the form of a good, for example, a magazine subscription. Or even a combination of the two. However, in accounting, no matter what the actual item or items are, it is the value of economic benefits from them that we are concerned about recording.

Classification of Prepayments

Prepayments are treated as an asset in accounting. Under the accounting equation, they go on the left hand of the formula, falling under the asset class. The financial statement is the statement of financial position (or the balance sheet) that reflects the asset, generally classified as a current asset.

Within the International Financial Reporting Standards (IFRS) conceptual framework, they define an asset along the lines of:

“… a financial arrangement that creates an obligation on a third party to expend economic benefits to our benefit due to past events”.

A prepayment meets this definition. Let’s use a rental arrangement to illustrate the point.

Financial Arrangement

In our case, this would be a rental agreement. We agree to pay a certain sum of money in rent to the landlord, and they decide to let us use their property as set out in the agreement.

Creates an Obligation on a Third Party

Our rental payments mean the landlord has to provide us with use of the property. They can’t go and rent it to some else or decide to use it themselves.

Expend Economic Benefits to Our Benefit

Our rental payments enable us to receive the benefits of using the property for our business activities.

So prepayments occur when we are entitled to receive economic benefits from something to be delivered to us in the future.

As a Result of Past Events

This last phrase sets a timing stamp on the recognition that the accounting standards don’t want us recording an asset for something that has yet to happen. In other words, all of the above must have taken place and be present at the end of the financial period we are making this balance day adjustment for.

Prepayment Example and Journal Entries

It’s probably best to work through an example of a typical prepayment and see what journal entries are required and how the calculations are made.

ABC Ltd has several rental agreements in place for storage it needs, and one of these units pays for 12 months in advance each year to take advantage of an attractive upfront discount offered by the landlord. On January 1st each year, ABC pays $6,000 for this storage unit. And has a balance date of 31 March.

Prepaid Expense

So let’s look at the initial entry made on January 1st and then work forward from there. In ABC’s cash books it would record the equivalent of the following journal entry:

It comes to the end of the financial year, 31 March, and ABC has to prepare its year-end accounts. Because the rent paid in advance is a material amount in the company’s accounts and ABC uses an accrual accounting system, it has to account for the prepayment of rent in this case.

An important note to make here. If ABC ran its accounting system on a cash basis, i.e. it only records transactions when cash moves, this type of adjustment is not required. The whole expense of $6,000 would be recognised in their accounts for the year ended 31 March.

However, they use the accrual system, and so we need to reflect where the economic benefits flow in and out of business. So we have to apportion the prepayment.

1 January to 31 March = 3 months of rent “economic benefit” consumed

This leaves us with nine months of economic benefits to still be received in the form of future rent. This is the amount we need to adjust for:

9 months / 12 months x $6,000 = $4,500

Balance Day Adjustment for Prepayment

We would enter the following journal entry in ABC’s general journal system to reflect the trigger of when prepayments will occur in ABC’s books:

You can see this second journal entry reduces the rental expense by $4,500, as these economic benefits have not been consumed in the reporting period ending 31 March. While the debit creates an asset (as defined above) of prepaid rent of $4,500.

Of course, we can’t carry this current asset on the books as the economic benefits it represents are being consumed each month. ABC prepares quarterly internal full accrual accounts, and so it’s time to make another adjustment. We know three months of rent have passed, and so the prepaid rent balance has to be reduced by: 3 months x $500 per month = $1,500.

We would enter the following journal entry in ABC’s general journal system:

You can see in this journal entry we bring to account the consumption of three months rent. This is a debit to the rent expense account of $1,500. We then have to reduce the prepaid rent asset account balance with a credit of $1,500.

Conclusion

We hope the above analysis and journal entries help to explain how prepayments occur in accounting. Keep in mind these amounts must, of course, be material to the business. For example, if ABC had expenses of say $10m per annum, it might not worry about bringing to account $4,500 of prepaid rent.