So what are Prepayments?

Prepayments or prepaid expenses are expenses paid in advance.

They are actually economic resources which are the current assets of a business which are expected to be used up or consumed during the accounting period of the business.

The portion that are used up during the accounting period are treated as expenses in the Income Statement whilst those not consumed are treated as a current asset which is called prepayment or prepaid expenses

Examples are: prepaid insurance (unexpired insurance),prepaid rent, prepaid advertising, prepaid road tax and prepaid property tax which are reflected in the current assets of the Balance Sheet.

Prepayments expensed into Income Statement following the Matching Concept

This in reality is following the matching concept. Those expenditures that are used up to match the revenue generated for the accounting period is EXPENSED off into the Income Statement.

What are the Accounting Treatment for Prepayments?

Basically there are two(2) ways of accounting treatments:

·Treat the prepayment initially as an expense in the Income Statement:

Debit: Expenses ( Income Statement)say $10,000

Credit: Bank/Cash $10,000

Being 100% take up of prepaid expenses as expenses in the Income Statement.

Next , at the end of the accounting period, use the following adjusting entry to transfer those portion that has not been used up to the Balance Sheet as current asset/prepayment

Accounting entry as follows:

Debit: Prepayment (Balance Sheet) $6,000

Credit: Expenses (Income Statement) $6,000

Being transfer of the portion of expenses not expired/consumed into prepayment account (balance sheet) leaving $4,000 as expenses in the Income statement.

· Another accounting method is to treat the expenditure of $10,000 as prepayments as current assets in the Balance Sheet instead of the first method of taking up as expenses

Debit: Prepayment (Balance Sheet) $10,000

Credit: Bank/Cash $10,000

Being initial complete take up as prepayment $10,000

Next, at the end of the accounting period, transferred the portion that has expired or used up as expenses into the Income Statement:

Debit: Expenses ( Income Statement) $4,000

Credit: Prepayment (Balance Sheet) $4,000

Being transfer from prepayment to expenses for the portion that has expired namely $4,000.

Salient point on the abovementioned methods of Accounting treatment of prepayment:

In both methods, whether initially being taken up into balance sheet or income statement respectively and then transferred out as expenses or as prepayments/current assets, only the portion of the expense that has actually expired or used up which in this case is $4,000 is matched against the revenue generated during the accounting period

Revenues received in advance:

Are money (cash or cheque) received in advance.

They are actually liabilities to the business as the business has still not earned the revenue because goods or services have still not been provided to the customers.

The portion that goods have been delivered or services being provided during the accounting period are treated as incomes in the Income Statement whilst those not earned yet are treated as a current liability which is called prepaid revenues, deferred revenues and unearned revenues

Examples are: deferred maintenance fees, unearned fee from advertising services

Illustration of Accounting Treatment of Revenue Earned In Advance:

Assuming Company A which is a publishing house received a cheque of $1,200 being 12 monthly issue of a magazine starting from 1 st June 2005. [ this means that the $1,200 is meant for the period from 1 st June 2005 to 31 st May 2006. The entity’s accounting period ends at 31 st December.

There are two(2) ways of accounting treatment:

(1) To record the receipt of this money INITIALLY as revenue in the Income Statement:
Debit: Bank $1,200

Credit: Subscription Revenue $1,200

Being initial receipt of subscription revenue earned in advance.

Next, at the end of the accounting period namely 31/12/2005, to take up the relevant portion that the company has NOT yet earned specifically from 1 st January 2005 to 31 st May 2006 [5 months x $100 which is $500]

Debit: Subscription Revenue $500

Credit: Unearned subscription revenue (Balance sheet) $500

Being transfer of the portion of unearned income to balance sheet.

(2) The second method is to initially record the whole $1,200 as Unearned subscription revenue as current liability in the Balance Sheet.

Debit: Bank $1,200

Credit: Unearned subscription revenue (Balance sheet) $1,200

Being initial take up of 100% of subscription money into balance sheet item.

Next, at the end of the accounting period, transfer from the unearned subscription revenue (balance sheet) the portion of EARNED portion as income in the Income Statement.

Debit : Unearned subscription revenue (Balance Sheet) $700

Credit : Subscription Revenue (Income Statement) $700

Being recognition of the portion of unearned subscription revenue as income.

At the end of the day, using either above-mentioned methods, only the earned portion which is $700( 1 st June to 31 st December 2005) being correctly taken up as income in the Income Statement leaving behind the balance of unearned portion of $500 as current liability (unearned subscription revenue account) in the Balance Sheet.

Revenues received in advance are RECOGNIZED AS INCOME IN THE INCOME STATATEMENT for only the portion of goods delivered or services/work-done being rendered. This is based on the PRUDENCE OR CONSERVATISM Concept.

Based on this concept, ONLY the ascertained portion is taken up as revenue/income, the balance of goods not delivered or work not yet done is taken up in the Balance Sheet. Only when work being done or goods actually being delivered, can they be matched and taken up into the Income Statement