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 prepayments in the financial statements.

Prepayments

Definitions

Prepayments

These are payments made in advance to suppliers or vendors for goods or services that will be received or consumed in a future accounting period.

It helps to contrast prepayments with accruals:

• With accruals, an expense has been incurred in the period (goods or services received) but has not yet been paid or recorded.
• 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 recognise 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.

This assumes the full payment was debited to the expense account when paid; the adjustment moves the future-period portion out of expense and into a prepayment asset.

Journal entry to record a prepayment:

Debit: Prepayment

Credit: Expenses

The expense is reduced in the statement of profit or loss to reflect only the amount consumed during the current period, while the prepayment is presented as a current asset on the face of the statement of financial position. The prepayment represents the amount that relates to the future period.

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 recognised 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.

Journal entry to reverse a prepayment:

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

1. Calculate the portion of payment that relates to the year ended December 31, 2024 (expense for 2024).

2. Calculate the portion of payment that relates to the subsequent year (prepayment as at Dec 31, 2024).

3. Prepare the year-end adjustment journal entries on December 31, 2024, to record the prepayments.

4. Show how the prepayments would be presented on the statement of financial position as at December 31, 2024.

5. Prepare the reversal journal entries that would be made during 2025 to recognise the prepaid expenses.

Illustration 2: ledger accounts and the effect on profit and net assets

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 payment:

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

The monthly rent is $18,000 ÷ 6 = $3,000. Of the 6 months, November and December 2024 (2 months) relate to 2024, so the expense for 2024 is $6,000. The remaining 4 months (January-April 2025) relate to 2025, so the prepayment at December 31, 2024 is $12,000.

The year-end adjustment journal entry at December 31, 2024 is:

Debit: Prepayment (rent) $12,000

Credit: Rent expense $12,000

Here’s how that adjustment, and the following year’s reversal, move through the rent expense and prepayment ledger accounts:

Rent expense account:

• 2024 - Debit: Nov 1, 2024, Bank, $18,000
• 2024 - Credit: Dec 31, 2024, Prepayment, $12,000
• 2024 - Credit: Dec 31, 2024, transferred to profit or loss, $6,000
• 2025 - Debit: Jan 1, 2025, Prepayment (reversal), $12,000
• 2025 - Credit: Dec 31, 2025, transferred to profit or loss, $12,000

Prepayment account:

• 2024 - Debit: Dec 31, 2024, Rent expense, $12,000
• 2024 - Credit: Dec 31, 2024, balance carried down, $12,000
• 2025 - Debit: Jan 1, 2025, balance brought down, $12,000
• 2025 - Credit: Jan 1, 2025, Rent expense, $12,000

At December 31, 2025, both accounts return to nil - the whole $12,000 prepayment relates to months that fall entirely within 2025, so the full balance is reversed to rent expense and no rent prepayment is presented at December 31, 2025.

Effect on profit and net assets: recording the $12,000 as a prepayment, instead of leaving it in rent expense, increases 2024 profit by $12,000 (expenses are $12,000 lower) and increases net assets by $12,000 (the prepayment is a current asset). Without the adjustment, both profit and net assets at December 31, 2024 would be understated by $12,000.