What are prepayments?

As we learned in the article Understanding Accruals – it has been a long-accepted accounting principle that revenue and costs should be recognised as they are earned or accrued, rather than when their cash value is received or paid.

If payments are made in the current period that partly relates to a future period (e.g. rates or insurance), a portion may be carried forward as a current asset – a prepayment – and matched to future accounting periods.

Prepayments are also called deferrals or deferred costs.

Let’s consider 2 examples:

1. The Annual Rates Bill

For example, an annual rates bill received in March – will cover the period from 01-Apr of that year to the 31-Mar the following year. Typically a rates bill will cover a 12 month period but be paid over 10 months in 10 easy installments.

The costs should be spread over 12 months in the management accounts as the costs apply to the whole year, but the cash flow will be spread over 10 months. Typically the cash is collected  between April and January so it is paid in full, 2 calendar months before the end of the rates year.

Say a £1200 rates bill is received on the 3rd March for 01-April this year to 31st March the next year.  The cost can be deferred over the coming year in 12 equal installments of £100 per month.

2. Annual Insurance Bill

An annual insurance bill also received in March, may still cover a 12 month period, but is likely to start and end on a specific date – say the 20th March one year, to the 19th March the next year.

In this case, a 12-month equal spread is not appropriate and we will need to consider the number of days in the relevant months at the start and end of the period. Say for the ease of the accounting entries – our insurance bill is also £1200 per year. We can either spread our insurance costs using an average months basis or actual days in yearly basis. The method you choose to spread the costs is up to you – so long as the method is sensible for the cost you are spreading and you try to be consistent when you are prepaying other costs.

Month Actual Days in Year Equal Months
March

20th – 31st = 12 Days (including the 20th and 31st)

12    £39.45

(£1200 x 12/365)

£38.71

(£100 x 12/31)

April 30 £98.63

(£1200 x 30/365)

£100
May 31 £101.92

(£1200 x 31/365)

£100
June 30 £98.63

(£1200 x 30/365)

£100
July 31 £101.92

(£1200 x 31/365)

£100
August 31 £101.92

(£1200 x 31/365)

£100
September 30 £98.63

(£1200 x 30/365)

£100
October 31 £101.92

(£1200 x 31/365)

£100
November 30 £98.63

(£1200 x 30/365)

£100
December 31 £101.92

(£1200 x 31/365)

£100
January 31 £101.92

(£1200 x 31/365)

£100
February 28 £92.05

(£1200 x 28/365)

£100
March

1st  – 19th = 19 Days (including the 1st and 19th)

19 £62.47

(£1200 x 19/365)

£61.29

(£100 x 19/31)

TOTAL 365 £1200 £1200

Let’s look at the accounting entries:

It’s the 3 March and we have received our annual rates bill. First, we will post the invoice.

Top Tip: Generally we prefer to see overheads posted to the profit and loss account and then moved out of the profit and loss (creating the transactional audit trail), instead of posting them straight to the balance sheet where they can be overlooked or forgotten.

 

March invoice for rates – you will enter this as a purchase invoice
Transaction Debit Credit
‘Local Authority’ Creditor £1200
Rates (P&L) £1200
Transaction Total £1200 £1200

Now that you have posted £1200 in March, we realise that the entire cost needs to be ‘prepaid’ or deferred to the balance sheet because this cost does not belong in March. If your year end is 31st March, then the entire cost will relate to the following trading year.  The cost will need to be spread over the period from April this year to March next year.

Our first journal entry is to defer the cost out of the profit and loss account.

03-March    Being the prepayment of the annual rates bill
Transaction Debit Credit
Rates (P&L) £1200
Prepayments (BS) £1200
Journal total £1200 £1200

Then we need to post a series of journals to write back our rates expenses over the 12 months to which they relate. This journal would need to be repeated 11 times, ie once for each future month to write back the cost over the full 12 month period.

01 April   Being the write back of prepaid rates (Month 1 of 12)
Transaction Debit Credit
Rates (P&L)  £100
Prepayments (BS)  £100
Journal total £100 £100

Once you have completed your series of journals, the balance in your prepayments account in the balance sheet should be nil.

If you have any queries on the content of this post, please contact us at [email protected].

Shares

By continuing to use the site, you agree to the use of cookies. more information

The cookie settings on this website are set to "allow cookies" to give you the best browsing experience possible. If you continue to use this website without changing your cookie settings or you click "Accept" below then you are consenting to this.

Close