How Do You Account for Prepayments
Prepayments, or prepaid expenses, are expenses paid in advance for goods or services that will be received in the future. They are considered assets for the business until the benefit of the prepayment is realized.
Here’s how you would typically account for a prepayment:
- When the prepayment is made: The company will debit (increase) a Prepaid Expense account and credit (decrease) Cash. This reflects that cash has been paid and a prepayment has been made.
- When the prepaid expense is utilized: Over the period of benefit, the company will debit (increase) an Expense account and credit (reduce) the Prepaid Expense account. This reflects the expensing of the prepaid amount over the period of benefit.
Example of How to Account for Prepayments
Example – Prepaid Rent:
Suppose a company, TechWorld Inc., pays $12,000 on January 1 for rent for the whole year. The journal entry at the time of prepayment would be:
Debit: Prepaid Rent $12,000
Credit: Cash $12,000
This entry indicates that TechWorld Inc.’s cash has decreased by $12,000, but it now has a prepaid rent asset of $12,000.
Then, at the end of each month, TechWorld Inc. would record the portion of the rent expense that has been used up:
Debit: Rent Expense $1,000 ($12,000 / 12 months)
Credit: Prepaid Rent $1,000
By the end of the year, the entire $12,000 would have been expensed, and the balance in the Prepaid Rent account would be $0.
Remember, the timing and recognition of prepaid expenses can be affected by the company’s accounting method and the materiality of the prepaid items. Always consult with an accounting professional for the correct treatment.
Example – Prepaid Insurance:
Imagine a company, BrightWidgets Inc., pays $1,200 on July 1 for a one-year insurance policy. The payment covers the period from July 1 this year to June 30 of the next year.
At the time of making the payment, the company records the entire $1,200 as a prepaid expense:
Debit: Prepaid Insurance $1,200
Credit: Cash $1,200
This journal entry reflects the decrease in cash and the increase in the Prepaid Insurance account.
As the insurance coverage is utilized month by month, the company will reduce the Prepaid Insurance account and record it as an expense. This would be done at the end of each month and would look like this:
Debit: Insurance Expense $100 ($1,200 / 12 months)
Credit: Prepaid Insurance $100
This journal entry reflects that $100 worth of insurance coverage has been used up in that month.
This process repeats every month. By the end of the one-year period, all $1,200 will have been shifted from the Prepaid Insurance account to the Insurance Expense account.
This ensures that the cost of the insurance is matched to the periods in which it is used, aligning with the matching principle in accounting. It also ensures that the company doesn’t mistake a prepaid expense for an available asset, giving a more accurate picture of the company’s financial position.
