What are prepayments?
A prepayment is an expense paid in advance that relates to a later accounting period, held on the balance sheet as an asset until it is used up.
What prepayments mean
Under accrual accounting, costs belong in the period they relate to, not the period you pay them. If you pay for something that covers months after your year end, the part relating to the future is a prepayment. It is not a cost yet, so it is taken out of the profit and loss account and shown on the balance sheet as a current asset.
Common prepayments include annual insurance premiums, rent paid quarterly in advance, software subscriptions paid yearly, and deposits for trade shows or events after the year end.
Example
A company with a 31 December year end pays a £2,400 annual insurance premium on 1 October, covering 1 October to 30 September.
- Three months (October to December) belong to this year: £600.
- Nine months (January to September) belong to next year: £1,800.
At the year end the bookkeeper posts a journal entry:
| Account | Debit | Credit |
|---|---|---|
| Prepayments (balance sheet) | £1,800 | |
| Insurance expense (profit and loss) | £1,800 |
This year's accounts show insurance of £600. Next year, the £1,800 is released back into the profit and loss account as the cover is used.
Why it matters for your business
Without prepayments, your profit would be understated in the year you paid and overstated the following year. That distorts the figures you use to make decisions, and for a company it shifts taxable profit between years. Getting prepayments right is part of producing accounts that comply with UK accounting standards.
Prepayments also matter for your current ratio, because they count as current assets.
Prepayments vs accruals
Accruals are the mirror image: costs you have incurred but not yet been billed for or paid, such as an electricity bill for December that arrives in January. Prepayments move costs forward out of this year; accruals bring costs back into it.
If you use the cash basis
Sole traders using cash basis accounting record expenses when paid and do not adjust for prepayments, which is one reason the cash basis is simpler. Limited companies must use accruals accounting and adjust for them.
It is one of several year-end adjustments the cash basis avoids.
Common questions
An asset. You have paid for something you have not yet received the benefit of, so the business is owed that future service. It sits in current assets on the balance sheet until it is used up.
Limited companies do, because their accounts must follow accruals accounting. Small items are often ignored on materiality grounds. Sole traders on the cash basis do not need to make prepayment adjustments. Your accountant will usually agree a sensible threshold with you, so only meaningful amounts are adjusted.
More accounts & bookkeeping terms
- Accounting equation
- Accounts payable
- Accounts receivable
- Amortisation
- Assets
- Bad debt
- Balance sheet
- Bank reconciliation