What is Prepaid Income?

Prepaid Income

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Prepaid Income

Prepaid income, also known as deferred income or unearned revenue, refers to money received by a company for goods or services that it has not yet delivered or performed. Because the company still owes the goods or services to the customer, the payment is not yet recognized as revenue, but as a liability.

In accounting, when a company receives a prepaid income, it records a debit (increase) to the Cash account and a credit (increase) to a liability account such as Unearned Revenue or Deferred Income. This reflects the company’s obligation to deliver goods or services in the future.

Over time, as the company fulfills its obligation to the customer—by delivering goods, performing services, or allowing the passage of time in the case of rent or subscription income—it gradually recognizes the deferred income as revenue. This involves debiting (decreasing) the Unearned Revenue account and crediting (increasing) a revenue account.

Prepaid income is commonly seen in businesses like publishing (for subscriptions), insurance (for premiums), software services (for annual subscriptions), and rental businesses (for advance rent payments). It’s crucial for businesses to carefully track and account for prepaid income to ensure revenues and liabilities are accurately stated in their financial statements.

Example of Prepaid Income

Let’s consider a magazine publishing company, MagzCo, which sells annual subscriptions to its magazine. Each annual subscription costs $120 and covers 12 issues, one per month.

A new customer, John, decides to subscribe to the magazine on January 1, 2023, and pays the full $120 for the year upfront. Here’s how this would be handled in MagzCo’s accounting:

Step 1: Receipt of Prepayment When MagzCo receives the $120 payment on January 1, 2023, it records this as prepaid income (or unearned revenue) with the following journal entry:

Debit: Cash $120
Credit: Unearned Subscription Revenue $120

At this point, the $120 shows as a liability (Unearned Subscription Revenue) on MagzCo’s balance sheet because MagzCo has an obligation to deliver 12 magazines to John over the next year.

Step 2: Recognition of Revenue Each month, as MagzCo sends a magazine to John, it can recognize $10 of revenue ($120 annual subscription fee / 12 months). The corresponding journal entry each month would be:

Debit: Unearned Subscription Revenue $10
Credit: Subscription Revenue $10

This process is repeated each month until the end of December 2023. By that time, all $120 will have been recognized as Subscription Revenue, and the Unearned Subscription Revenue balance will be $0.

This process ensures that MagzCo recognizes its subscription revenue in the periods when the magazines are actually delivered, which provides a more accurate picture of the company’s financial performance. This complies with the revenue recognition principle and the matching principle in accounting.

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