What is a prepayment? (Definition, Explanation, Journal Entry, and Example)

Definition

Prepayment is an accounting term referred to the types of expenses not incurred yet but for which payment is made in advance.

As the economic benefits from such resources are not taken yet this is why it is classified as an asset rather than an expense and shown on the face of the balance sheet rather charging in the profit and loss statement.

Explanation

Prepayments are those payments, the benefits of which are expected to flow in the future. Here it is necessary to note the difference between the prepayments and advance payments.

Pre-paid is an amount more often paid for the expenses, the benefits from such payments will flow to the entity in the following financial years however the advance payment is the payment made for goods/services without the receipt of goods/services.

In almost all cases, the payment for goods and services is made after the benefits of such services and goods are taken. For example, a payment to the contractor for building a five-story building is made after the completion of the whole project or on an installments basis as per the stage of completion.

In both of the cases whether payment is made at the end of the project after completion or installments basis are made after taking the benefits from the contractor’s services.

However, there are some services, for which payment is compulsory to be at the beginning of the period before taking economic benefits from such goods/services such as the pre-paid rent and payment made for insurance cover under a contract.

There are certain rules set by the accounting standards-setting organizations, according to which the economic resources owned by the entity must be recorded in books of the entity.

According to these rules, all those economic resources the benefits from which yet to taken are classified as an asset and the benefits of the resources of which are already taken shall be charged in the profit and loss statement.

This is the reason the pre-paid expense is classified as an asset and shown on the face of the balance sheet because the benefits from such payments will flow to the entity in upcoming financial years. Thus in short prepayment is the payment made in advance before its accrual.

There are many types of prepayments these payments are mostly made in a corporate environment but it can also be made on an individual basis.

Prepayments made in a corporate environment are made in one accounting period and it will provide benefit in upcoming accounting periods. The main difference between usual expenses is prepaid expense is the recording of expense i.e the usual expense is charged to profit and loss in a single step.

However the pre-paid expense is two steps, that is first it is recorded on the balance sheet as an asset and then charge to the profit and loss statement upon the fulfillment of conditions attached to the pre-paid expenses.

Journal Entry

The prepayments made for any expense is a business activity, which is needed to be recorded in order to show the true and fair and clear financial picture of the entity.

For example, if we are making a prepayment to any insurance company for ensuring the factory building then we will record the event as a debit to the prepaid insurance account and credit to the cash or bank account.

Such prepaid insurance amount will be classified on the asset side of the balance sheet and charge to the profit and loss account as an expense upon completion of the insured period.

DateAccount TitleDebitCredit
XXPrepaid InsuranceXX 
XXCash XX

Examples

There are many examples where the business entity is required to pay for expenses in advance. Such payments are made in advance and upon the payment it is recorded as an asset, the examples of such payments are listed as under:

  • Advance rent paid for the occupation of a space for carrying on a business activities
  • Payments made for the insurance of a business asset in order to minimise the loss in case of any mishap
  • Assets acquired in order to complete the business operations and preparation of goods and services
  •  Salaries paid to the employees if paid in advance according to the terms of contract defined in the employment contract
  • Any payments made to the authorities in advance under the law or regulation
  • Payments made for the utilities in advance; and
  • Interest payment made in advance

This is not an exhaustive list of the prepayments made by the business entities, there may be many other examples of payments made for the expenses according to the nature of the business entity.

Operating income Vs Net Income

Operating Income

Operating income is the residual amount of revenue left after deduction of the cost of goods sold (COGS) and operating expenses from the revenue or net sales during the specific period or during the year. It is one of the measures of the profitability of the operations of an organization.

The increase or decrease of operating income are really depending on revenue or net sales and cost of goods sold. Operating income increase will resut increase of gross profit margin.

It infers investors and owners about the amount of revenue that would eventually turn out to be profits for the company.

It is one of the primary indirect indicators of the measure of efficiency of an entity. Higher the operating income, higher is the operating efficiency and profitability from the core operations.

Operating income can be calculated by the formula:

Operating income = Total Revenue – Direct Costs – Indirect Costs

                                                          Or

Operating income = Gross Profit – Operating Expenses – Depreciation – Amortization                

Or

Operating income = Net Earnings + Interest Expense + Taxes

Net income

Net Income is the profit remaining after all costs incurred during the period have been subtracted from sales revenue. It is important since it helps to calculate Earnings Per Share (EPS). It is the last line of income statement and often referred as “Bottom line number”.

It includes every type of income and expenses. If a company is able to steadily increase the net income of a company over a period of time, its share price will eventually rise.  

Net income = Operating Income – Expenses – Taxes

The differences between Operating Income and Net Income are discussed below:

BasisOperating IncomeNet Income
DefinitionIt signifies the income from the principal revenue-generating activities of the company.It is the income generated from all the operations of the company.
SignificanceIt calculates how much revenue converts into profit.It depicts the earning potential capacity of the company.
FormulaGross income- Operating expense- Depreciation and amortizationOperating income + Other Income-Interest expense + Extraordinary income- Extraordinary Expense-Taxes
TaxesTaxes are not considered to calculate income.Taxes are deducted to calculate income.
UsesUsed to calculate ROCE (Return on capital Employed)Used to calculate EPS, ROA or ROE
EvaluationIt gives evaluation of operational performance of company.It simply offers earnings evaluation rather performance evaluation.
PositionIt sits much above the net income in the income statement.It sits at the bottom of the income statement.
IncomeIt doesn’t include profit/loss from investment or sale of capital goods.It includes profits/loss from investment or sale of capital goods.
TransferIt is not transferred to capital Account of shareholders.It is transferred to capital account of shareholders.
PresentationIt is presented in income statement only.It is presented in income statement and balance sheet
Non-operating incomeIt doesn’t include non-operating income.It includes non-operating income.
Non-operating expensesIt doesn’t include non-operating expenses.It includes non-operating expenses.
Other namesIt is also called Earnings Before Income and TaxIt is also called Earning After Tax
Taxation purposeThis income is not used in calculating taxable income.This income is used to calculate total taxable income.
PurposeIt is used to understand and eliminate the unnecessary operating expenses.It is useful in knowing the financial performance of the entity.
Ratio usedOperating profit ratio is used to gauge operating profit vis-à-vis sales.Net profit ratio is used to gauge operating profit vis-à-vis sales.
Share priceIt doesn’t affect share price.Increase in net profits increase the share price.
Use to investorsInvestors are not interested in knowing the operating profit.A huge net profit results in distribution of higher dividends to shareholders.
Leverage effectOperating profit doesn’t consider leverage effect.Net profit considers leverage effect as interest expenses are deducted.
ValuationOperating profits are not considered for valuation purpose.Net profit is the profit considered for valuation of a company.
DividendDividend is not distributed on the basis of this income.Dividend is distributed as a percentage of net income.
ImportanceThis income is useful for the operations management team.This is useful for shareholders of a company.

Accrued Revenue

Introduction

Under the accrual basis of accounting, the financial transactions are to be recorded as and when they occur. When the seller provides services or sells goods, then he has to recognize the revenue even if the customer has not made payment.

This is in line with the accrual concept. It is the revenue that the company earned after selling its goods or services although it hasn’t received its payment yet.

This recording of transactions is even mandated as per the Revenue recognition principle that defines when revenue is to be recorded. As per AS 9 on revenue recognition, revenue can be only recognized when these two conditions are fulfilled:

 It is usually recorded as a current asset because the gap period between earning revenue and receipt of cash is usually less than a year or a working capital cycle. It is shown in balance sheet as current asset when the related revenue is shown in the income statement.

As the payments are received, the accrued revenue gets deducted by the amount of cash received, with no further effect on the income statement. A high accrued revenue signifies that the business is not receiving timely payments for its products or services and can be alarming for the financial health of the company.

The conditions required for booking the accrued revenue are as follows:

Situations when accrued revenue arises and needs to be booked:

Example of accrued revenue:

A sold goods to B on December 30,2019 for Rs 5000. He closes the books of accounts on December 31. He received the payment on January 10,2020. How should he record revenue?

Here,

On December 31, 2020, A should recognize the revenue of Rs 5000 after the conditions of revenue recognition have been duly met. Such conditions are

The journal entries to be passed are:

At the point of sales being made:

DateParticularsDebitCredit
 Debtors A/C5000 
         To Sales revenue 5000

At the time of receipt of cash:

DateParticularsDebitCredit
 Cash A/C  5000 
         To Debtors 5000

Accrued revenue is the revenue that has been recognized but not yet realized. It is also called unbilled revenue. It is recorded when there is mismatch between time of the payment and delivery of goods and services.

This can arise in following cases:

Presentation of accrued revenue in financial statements:

Accrued revenue is shown as adjusting journal entry under current assets category in the balance sheet and as an earned revenue in the income statement of the company. When the payment is cleared, it is recorded as an adjusting entry to the asset account for accrued revenue.

Example:

A bank grants loan to customer of Rs 500000 at 10% per annum on January 1,2020. The amount will be collected after a period of 1 year. After the passage of 1 month, the bank is entitled to a revenue of 1-month interest. Hence, the entry would be:

DateParticularsDebitCredit
Jan 31Interest receivable A/C Dr4167 
         To Interest income A/C 4167

Interest receivable of Rs 4167 would be shown as current asset in the balance sheet and as earned revenue in P&L statement as per accrual principle.

Example:

ABC IT services company agrees to build a software for PQR company in 12 months for Rs. 400000. According to the contract, ABC is expected to deliver the first milestone in 6 months which is valued at Rs. 250000. A second milestone would be delivered at the end of the contract in another 6 months.

Hence ABC must record accrued revenue at the end of first milestone. The entry would be:

DateParticularsDebitCredit
June 30Accrued revenue A/C Dr250000 
         To Revenue A/C 250000

After the completion of the milestone and total bill being issued, ABC must record the following:

DateParticularsDebitCredit
Dec 31Revenue A/C Dr250000 
         To Accrued revenue A/C 250000
DateParticularsDebitCredit
Dec 31Accounts receivable A/C Dr400000 
         To Revenue A/C 400000

 When cash is received, the entry is

DateParticularsDebitCredit
Dec 31Cash A/C Dr400000 
         To Accounts receivable A/C 400000

Operating lease on the balance sheet

Introduction

A lease is defined as a contract or part of a contract that conveys the right to use an asset for a period of time in return for a quid-pro-quo. They are considered as off-balance sheet financing items. It means that leased assets and liabilities are not reflected in the balance sheet of a company. Lessor retains the ownership of the leased asset.

As per IFRS 16,

 For the lessor, an operating lease is defined as every lease other than the finance lease.

IFRS 16 mandates lease to be termed as a finance lease if all the following conditions are met:

  • There is the transfer of ownership to the lessee at the end of the lease period
  • The lease contains a purchase option by the lessee
  • The period of the lease exceeds 75% of the economic life of the asset
  • The present value of lease payments should exceed 90% of the asset’s fair market value.

If none of these conditions is met, the lease would be classified as an operating lease.

Operating lease is used to lease for a short period of time and is similar to renting as the transfer of ownership is not involved. Periodic annual lease payments are treated as operating expenses of the company and are shown in the income statement of the company. The firm doesn’t own the asset hence, the asset is not shown in the balance sheet on the asset’s side. Depreciation is not calculated for assets taken under an operating lease. The lessee has the option either to buy the asset or return the asset to the lessor at the end of the lease period.

For the lessee, the distinction between operating lease and finance lease has been extinguished. All leases will be shown on the balance sheet as liabilities, at the future value of the present lease payments, along with the asset showing the right to use the asset over the lease period.

The advantages of operating lease are given below:

  • Greater flexibility: Companies can replace or update the assets more often hence; it provides more flexibility to the lessor.
  • There is no risk of obsolescence as there is no transfer in ownership
  • Accounting is simpler
  • Lease rentals are tax-deductible.

Features of operating lease:

  • Lessor retains the right to the ownership of the asset.
  • The lease agreement doesn’t contain bargain purchase option.
  • PV of lease payments is lease than 90% of the fair market value of the asset.
  • Lease rentals are shown as operating expenses and charged to P/L Account.
  • Lessee has the right to use only, the risk and benefits lie with the lessor. Lessee pays the costs of maintenance of the asset.
  • The term of the lease is less than 75% of economic life of an asset.

Accounting of operating lease:

Lessee records rental payments as expense in the books of accounts and lessor records the property as an asset and depreciate it over its useful life.

Impact of operating lease on financial statements:

The effect of operating lease on the balance sheet is given below:

Effect on the income statement: Lease payments will be expensed in the P/L statement.

Effect on cash flows:

  • Lease payments are deducted from cash flow from operations.
  • Operating leases do not affect the lessee’s liabilities and hence, are off-balance-sheet items
  • Footnote disclosure of lease payment for each of the lease life is required

Example of an operating lease:

Let us take the example of a company that has entered into an operating lease agreement for an asset and has agreed to a rental payment of Rs. 24000 for a period of twelve months. Since it is an operating lease accounting, the company will book the lease rentals uniformly over the next twelve months, which is the lease term. The monthly rental expense will be calculated as follows,                            

Rental expense per month = Total lease rental / No. of months = Rs.24,000 / 12 = Rs.2,000

Now, let us have a look at the journal entry for recording the operating lease rental transaction for each month. Each month company will record the following entry:

ParticularsDebitCredit
Rental expenses A/C Dr2000 
        To Cash 2000

Operating lease accounting by both the parties:

The lessee should recognize the following during the lease period:

  • Cost of the lease in each period where the total cost of the lease would be allocated over useful life on the straight-line method
  • Any variable lease payments which have not been included in lease obligation
  • Any impairment of the right-of-use asset

The lessor should recognize the following;

  • Lease payments are charged to P/L Account over the term of the lease on the straight-line method.
  • Variable lease payments are recorded in P/L in the same reporting period of the events which caused lease transaction
  • Initial direct costs are recognized as expense over the term of the lease.

Equity Vs Liabilities

There are three concrete parts to the Balance sheet. The parts comprise of assets, liabilities, and Equity. These three parts are also based on the accounting equation is:

Shareholder’s equity= Assets – Liabilities

In simple words, the primary difference is that equity is the investors’ resources in the company and liabilities are the outsiders’ resources used by the company for time being for consideration called interest or for operating purposes. Now, let’s discuss the top 7 differences on the basis of the following:

Definition

Equity is the capital of the business. It is the money that is invested by the owner of the business i.e., the shareholders of the company. In other words, equity can be defined as the assets which are created by the company after discharging its liabilities. It is always shown on the liabilities side of the balance sheet. It has a credit balance. 

Liabilities are the obligations of the company arising out of past actions where is a probable outflow of money in the future. It is shown on the left side of the balance sheet. It is classified as a current and non-current liability.

Classification

Equity is two types with various iterations in them in terms of features. These are equity share capital and preference share capital. The retained earnings are attributable to equity shareholders. Hence, it also forms part of equity. Equity is also termed as stockholders’ equity. Technically equity does not have any classification.

Liabilities can be classified in two categories as Long-term liabilities or Non-current liabilities and Current Liabilities. Long term liabilities are those liabilities which are payable after one year. Current liabilities are those liabilities which are payable within current year.

Line Items

Line items are the presentation items as being shown in balance sheet. Equity consists of contributed capital, treasury stock, preferred shares and retained earnings. It is shown on Liabilities and Capital Side and under journal entries, these items are always credit items.

While making journal entries, liabilities are always credited unless there in decrease in liabilities. Liabilities consist of Non-current liabilities and Current liabilities. The line items consist of notes payable, long term debts, advance receipts, accounts payables, etc

Nature

Equity is the kind of fund invested by the shareholders to accrete value i.e. generate profits and optimize the value of the company as a whole.

On the other hand, liabilities are resources from the outsiders for the time being either a result of arrangement or transaction. The liabilities out of arrangements are long term liabilities and out of transactions are current liabilities.

Accounting Equation

The fundamental concept of the accounting equation is based on

Assets = Liabilities + equity

Here, Equity can be derived by subtracting liabilities from assets. Liabilities on the other hand is derived by subtracting equity from assets.

Assets and Equity both are balance sheet items. However, they are closely linked to profit and loss statement. Retained earnings is part of equity. Every year, the net profits are transferred to retained earnings after making the required payment of dividends.

On the other hand, liabilities are not directly related with income statement. However, all those payables which are accrued for the current year are still being shown on both income statement and balance sheet due to concept of accruals.

Outflows

Under equity, outflows are necessary only under the case of dividend distribution or when the company is liquidated.

On the other hand, there is regular payments being made to current liabilities and occasional cash flows to long term liabilities.

The summary of differences between them are given below:

Basis of difference EquityLiabilites
DefinitionIt is the money invested by owners in the businessIt is the money owed by the company.
PurposeUsed for buying assets or discharging debts of companyLaibilities are burden to the company and are paid off by the company in due course.
ClassificationDivided into equity share capital, preference share capital, reserves and surplus etc.Classified as current and non-current liabilities.
OwnershipEquity is the fund of owner.Funds go out from the company in payment of liabilities.
Accounting equationEquity= Assets- LiabilitiesLiabilities = Assets- Equity
NatureEquity is the source of funds to acquire resourcesLiabilities arise during procurement of funds and application of funds.
Link with income statementRetained earnings link equity with income statement.There is no direct link between liabilities and income statement
Line itemsEquity consists of contributed capital, treasury stock, preferred shares and retained earnings.The line items consist of notes payable, long term debts, advance receipts, accounts payables, etc

Equity Vs Assets

There are three concrete parts to the Balance sheet. The parts comprise of assets, liabilities, and Equity. These three parts are also based on the accounting equation is:

Shareholder’s equity= Assets – Liabilities

In simple words, the primary difference is that equity is the investors’ resources in the company and assets is that of the company whose balance sheet is prepared. Now, let’s discuss the top 7 differences on the basis of the following:

Definition

Equity is the capital of the business. It is the money that is invested by the owner of the business i.e., the shareholders of the company. In other words, equity can be defined as the assets which are created by the company after discharging its liabilities. It is always shown on the liabilities side of the balance sheet. It has a credit balance.  

Assets are the resources controlled by the entity from which the future economic benefits are expected to flow to the enterprise. Examples include land and building, furniture, debtors, stock, cash in hand etc. Assets are shown on the debit side of balance sheet.

Classification

Equity is two types with various iterations in them in terms of features. These are equity share capital and preference share capital. The retained earnings are attributable to equity shareholders. Hence, it also forms part of equity. Equity is also termed as stockholders’ equity.

Assets can be classified as tangible assets (can be touched) and intangible assets (can’t be touched). Examples of tangible assets are land and building, furniture etc. Examples of intangible assets are goodwill, patents, copyright, trademark etc. Assets are the application of funds hence; they have a debit balance.

Line Items

Line items are the presentation items as being shown in balance sheet. Equity consists of contributed capital, treasury stock, preferred shares and retained earnings. It is shown on Liabilities and Capital Side and under journal entries, these items are always credit items.

While making journal entries, assets are always debited unless there in a decline in assets. Assets consist of Non-current Assets and Current assets. Non-current assets consist of fixed assets and intangible assets. Current assets consist of cash and cash equivalent, inventory, accounts receivables and prepaid expenses

Nature

Equity is the kind of fund invested by the shareholders’ to accrete value i.e. generate profits and optimize value of the company as a whole. On the other hand, Assets are resources of the company needed to run daily affairs of the enterprise. Current assets are for example very helpful in operating cycle of the revenue.

Accounting Equation

The fundamental concept of the accounting equation is based on

Assets = Liabilities  + equity

Here, Equity can be derived by subtracting liabilities from assets. Assets on the other hand is the sum of equity and liabilities.

Assets and Equity both are balance sheet items. However, they are closely linked to profit and loss statement. Retained earnings is part of equity. Every year, the net profits are transferred to retained earnings after making the required payment of dividends.

On the other hand, depreciation is operating expense in income statement which is transferred to accumulated depreciation which is reduced from the historical cost of the asset to show assets at written down value.

Depreciation & amortization

There is no depreciation in the equity. While fixed assets are reported at historical cost i.e. gross fixed assets less accumulated depreciation to arrive at written down value. A similar case is for amortization which is applicable for intangible assets.

Comprehensive differences between Equity and Assets

The differences between equity and assets including above top 7 differences and others are given below:

Basis of difference EquityAssets
DefinitionIt is the money invested by owners in the businessThey are the resources controlled by the entity.
PurposeUsed for buying assets or discharging debts of companyGives economic benefits to the entity
CategorizationNo categoryClassified as fixed assets and current asset
OwnershipEquity is the fund of the owner.Assets are the property of company. Owner doesn’t have right over the assets of company.
Accounting equationEquity= Assets- LiabilitiesAssets= Equity + Liabilities
BalanceIt has credit balanceIt has debit balance.
Presentation in balance sheetReflected on the left side i.e., liability side of balance sheetReflected on the right side i.e., asset side of balance sheet
Accounts typeIt is personal accountIt is a real account
Accounting principleIt is based on principle of Cr the giver.It is based on what comes in.
Reduction in valueThere is no reduction in valueThere is reduction in value due to wear and tear.
AppreciationThere is no appreciation in equityAssets value get appreciated in due course of time
DepreciationEquity don’t get depreciatedThere will be a gradual decline in its value due to depreciation
Line itemsEquity comprises capital, retained earnings, reserves, and surplusAssets comprise land and building, cash and cash equivalent, receivables etc.
NatureEquity is the source of funds to acquire resourcesIt is the resource required to operate a business
ReportingIt is reported at book valueIt depends on the asset whether it will be recorded at book value or market value
CollateralEquity can’t be kept as collateral for the loan.Assets are kept as collateral for loan.