Prepayments can be related to expenses as well as revenues, depending on whether an entity has paid cash in advance, or has received cash in advance, respectively. If it is related to an expense and payment is made by an entity, it is known as prepaid asset. Whereas if it is related to income and payment is received by an entity, it is known as deferred income, which is a liability.
When an entity pays an amount as consideration for some goods or services which will be received by the entity in future, that payment is not recorded as expense at the time of payment. It is recorded as a prepaid asset and is realized upon receipt of goods or services.
- If the prepaid asset is related to goods, it will be realized when the goods are received and another asset such as inventory, property, plant and equipment etc. is recognized. If the goods received are related to revenue expenditure, then such prepaid asset is realized with the corresponding effect recorded as expense in income statement.
- If the prepaid asset is related to services, it will be realized when related services are received, which are often received over a period of time. As the services are received, prepaid asset is realized with the corresponding effect recorded as expense in income statement. For example, Ricardo Garments Inc. has paid an insurance premium of $3000 on 1 October. Term of insurance coverage is one year. It is recorded as prepaid insurance at the time of payment. At year end, three months have been passed, which means that 25% of the total term of insurance has been passed, so 25% of $3,000 (i.e. $750) should recorded as insurance expense and prepaid insurance should be reduced accordingly. Another common example of prepayments is prepaid rent which is also initially recorded as prepaid asset and is charged to income statement as rent expense over the term of prepayment.
Prepayments are usually current assets, however, prepayments can be non-current as well depending on the timeline of its realization. If the prepaid asset is expected to be realized after 12 months from the reporting date, it will be considered as non-current asset. For example, if a prepaid asset is an advance payment given for a machinery which is expected to be received after one year from the current reporting date, then it will be treated as non-current asset.
To understand how journal entries are recorded for prepayments, let’s use the above-mentioned example of Ricardo Garments Inc.
|1 Oct||Prepaid insurance||3,000|
|(Recording payment of insurance premium covering the insurance period of one year)|
|31 Dec||Insurance expense||750|
|(Recording insurance expense based on the proportion of insurance term that has been passed)|