Prepayments
Prepayments ensure expenses are recorded in the correct accounting period. This chapter explains how to adjust payments made in advance, including the journal entries, reversals, and the impact on financial statements under the matching principle.
Learning objectives
By the end of this chapter, you should be able to:
- Apply accrual accounting to prepayments.
- Calculate the adjustments needed for prepayments when preparing financial statements.
- Illustrate the process of adjusting for prepayments when preparing financial statements.
- Prepare manual journal entries and update the general ledger accounts for the creation and reversal of prepayments.
- Identify the impact of prepayments on profit and net assets.
- Report accrued expense in the financial statements.
Prepayments
It helps to contrast prepayments with accruals:
- With accruals, goods or services have already been received during the accounting year, but the invoice hasn’t been received yet.
- With prepayments, payment has already been made (with or without a formal invoice) for goods or services that will be supplied or delivered in a later period.
Because of the matching principle, you don’t expense the full payment just because cash has been paid. Instead, you recognize as an expense only the portion that relates to the current accounting period.
The portion that relates to a future period is called a prepaid expense. Since the payment has already been made, that future portion is recorded as a prepayment (a current asset) on the statement of financial position.
Reversal of prepayments
The prepayment (asset) represents the amount that relates to a future period. In the subsequent year (the year the goods or services are actually consumed), that balance should be recognized as an expense.
To do this, you pass a journal entry that transfers the amount from the prepayment (asset) ledger account into the expense ledger account.
The journal entry would be:
Debit: Expenses
Credit: Prepayment
Illustration 1: Prepayments
A company prepares its financial statements annually with a year-end of December 31st. During the year ended December 31, 2024, the company made the following payments:
On March 1, 2024, the company paid $24,000 for a comprehensive business insurance policy covering 24 months (March 1, 2024, to February 28, 2026). The payment was initially recorded as:
Debit: Insurance Expense $24,000
Credit: Bank $24,000
- Calculate the portion of payment that relates to the year ended December 31, 2024 (expense for 2024). Do you know the answer?
- Total paid: $24,000 for 24 months (March 1, 2024 - February 28, 2026). The monthly cost will be $24,000 ÷ 24 = $1,000 per month.
- Period analysis - Months in 2024 is March - December = 10 months
- Expense for 2024: 10 months × $1,000 = $10,000
- Calculate the portion of payment that relates to the subsequent year (prepayment as at Dec 31, 2024). Do you know the answer?
- Period analysis: If 10 out of the 24months relates to 2024, then 14months relates to the subsequent years.
- Prepayment at Dec 31, 2024: 14 months × $1,000 = $14,000
- Prepare the year-end adjustment journal entries on December 31, 2024, to record the prepayments. Do you know the answer?
Debit: Prepayment (Insurance) $14,000
Credit: Insurance Expense $14,000
Since the total insurance expense of $24,000 was recorded when payment was made, the expense must be reduced so that only the portion relating to 2024 remains in profit or loss.
- Expense relating to 2024 is $10,000.
- The remaining $14,000 relates to future periods, so it is reclassified to a prepayment (asset).
This is why $14,000 is credited to Insurance Expense (to reduce it) and debited to Prepayment (Insurance).
- Show how the prepayments would be presented on the Statement of Financial Position as at December 31, 2024.
Statement of Financial Position (As at December 31, 2024):
Current Assets: Prepayments $30,000
- Prepare the reversal journal entries that would be made during 2025 to recognize the prepaid expenses. Do you know the answer?
- Period analysis - Months in 2025 is January - December = 12 months
- This means 2 months out of the 14 months will relate to 2026, while the remaining 12months relate to 2025.
- Expense for 2025: 12 months × $1,000 = $12,000
- Remember, the prepayment balance in 2024 was $14,000. Since the 2025 portion has now occurred, it should be moved from the prepayment account to insurance expense under the matching principle. The journal entry would be:
Debit: Insurance expense $12,000
Credit: Prepayment $12,000
Being the reversal of insurance prepayment for 2025.
The entry would reduce the prepayment balance to $2,000, which will be presented as a current asset in the statement of financial position.
Illustration 2: Self review
A company prepares its financial statements annually with a year-end of December 31st. During the year ended December 31, 2024, the company made the following payments:
On November 1, 2024, the company paid $18,000 for office rent covering 6 months (November 2024 to April 2025).
The payment was initially recorded as:
Debit: Rent Expense $18,000
Credit: Bank $18,000
- Calculate the portion of payment that relates to the year ended December 31, 2024 (expense for 2024). Do you know the answer?
- Total paid: $18,000 for 6 months. The monthly cost will be $18,000 ÷ 6 = $3,000 per month.
- Period analysis - Months in 2024 is November - December = 2 months
- Expense for 2024: 2 months × $3,000 = $6,000
- Calculate the portion of payment that relates to the subsequent year (prepayment as at Dec 31, 2024). Do you know the answer?
- Period analysis: If 2 out of the 6 months relate to 2024, then 4months relates to the subsequent years.
- Prepayment at Dec 31, 2024: 4 months × $3,000 = $12,000
- Prepare the year-end adjustment journal entries on December 31, 2024, to record the prepayments. Do you know the answer?
Debit: Prepayment (rent) $ 12,000
Credit: Insurance Expense $12,000
Since the total rent expense of 18,000 was recorded when payment was made, the expense must be reduced so that only the portion relating to 2024 remains in profit or loss.
- Expense relating to 2024 is $6,000.
- The remaining $12,000 relates to 2025, so it is reclassified to a prepayment (asset).
This is why $12,000 is credited to the expense account (to reduce it) and debited to Prepayment (rent).
- Show how the prepayments would be presented on the Statement of Financial Position as at December 31, 2024.
Statement of Financial Position (As at December 31, 2024):
Current Assets: Prepayments $12,000
- Prepare the reversal journal entries that would be made during 2025 to recognize the prepaid expenses. Do you know the answer?
- Period analysis - Months in 2025 is January - April= 4 months
- Expense for 2025: 4 months × $3,000 = $12,000
- Remember, the prepayment balance in 2024 was $14,000. Since the 2025 amount is due (i.e., occurred), it will be moved to the rent expense due to the matching concept. The journal entry would be:
Debit: Rent expense $12,000
Credit: Prepayment $12,000
Being the reversal of insurance prepayment for 2025.
The entry would reduce the prepayment balance to $2,000, which will be presented as a current asset in the statement of financial position.