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.
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.
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.
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.