A prepayment occurs when an expense is paid for in the current year but all or part of the cost should be charged as an expense next year. It therefore arises when a business has paid for something in advance during one accounting period but does not get the benefit of all or some of what it has paid for until the next. Therefore, it is in effect the ‘opposite’ of an accrual.
If an adjustment is not made for the prepayment then the accounts will not be giving a true reflection of the position of the business. If the business has paid for something but not yet received the benefit, then the profit of the business will be artificially low.
Dual effect of prepayments
Prepayments are recorded in an expense account and an asset account.
- Expense: The relevant expense account is reduced so that it records the correct amount of ‘benefit’ used in the accounting period.
- Asset: An asset account is created because the business has paid certain sums in advance and can look forward to receiving the benefit in the next accounting period.
Prepayment year-end adjustment
When you are given a preliminary trial balance:
- the relevant expense account will show the balance on the account before taking into account the prepayment.
- there will be no prepayment current asset account for the year in the list of account balances.
To make the year-end adjustment for prepayments, you should therefore:
- deduct the amount of the prepayment from the relevant expense account in the trial balance. The reduced expense will be included in the profit & loss account; and
- include the amount of the prepayment as a current asset in the balance sheet.
Example
Blooms Florists (‘Blooms’) has paid £24,000 rent for its new shop. The rent was paid on 1 September when they moved in to the shop, for 12 months in advance. Blooms has an accounting year end of 31 December.The trial balance will show that Blooms has paid £24,000 of rent in the accounting year. However, Blooms should only be paying rent in the present accounting period for the four months of September, October, November and December (i.e. £8,000, ((£24,000 ÷ 12 months) x 4 months)). The rest of the £24,000 (£16,000) should be accounted for in the next accounting period. The figure of £16,000 is the amount that Blooms has prepaid in respect of rent.
The correct figure of £8,000 must be shown in the Rent expense account on the Profit and Loss Account.
The £16,000 (i.e. the amount of the prepayment) will be shown in a Prepayment current asset account on the Balance Sheet since the business has yet to enjoy the benefit of the rent already paid.