Prepayment
A financial term that refers to a situation where the debts or dues are paid off before the due date arrives.
What is Prepayment?
Prepayment is a financial term that refers to a situation where the debts or dues are paid off before the due date arrives. It is commonly stated as an advance payment of the settlement of any debt loan or expense.
It is considered an asset, recorded as a current asset on the asset side of the company's balance sheet and in the income statement. Generally, it refers to the advance payment of future expenses or any debt.
It is recorded as current assets under the assets side in the balance sheet as it is assumed that the company will endure its benefits in the future. It has a debit balance and is recorded using the following journal entry:
| Dr. Prepayment a/c | XXX | |
| Cr. Cash a/c | XXX |
Some of the everyday prepayment transactions in the company are for loans, insurance, any dues or expenses, etc.
These advance payments may only sometimes be rewarding; for example, a lender may impose a penalty for early debt clearance.
It can be settled for operating and non-operating expenses paid before the due date or in advance. It always has a debit balance while preparing the accounts for the company.
These payments can be further categorized into complete and partial prepayments. Complete means the full fee for the liability before its due date, and the latter implies payment of a part of the liability.
These are not considered financial assets, as people often mistake it, but rather are a type of debtor for the company. These entries can be recorded using 2 methods, one being the asset method and the other being the expense method.
How Does Prepayment Work?
Prepaid expenses are those costs or expenditures that have been paid for in advance but are not listed in the company's financial statements. In other words, it is a type of future expense for which a business has already paid.
Understanding how the double-entry bookkeeping system accounts for prepayments is crucial. The balance sheet and income statement are both impacted by advance payments.
Sometimes purchasing goods or services from a vendor in advance can get you a great deal or considerable discounts.
Many people and companies opt to pay off their debts using extra money. In addition to easing off the debt they hold, repaying the loan sooner helps reduce the interest rate imposed on the loan.
There are certain risks involved in it, which are known as prepayment risks, which occur when the principal amount of the fixed asset is paid off before the due date. It has an impact on corporate bonds and mortgage-backed securities (MBS).
Before choosing corporate bonds over government bonds, investors should consider both default and prepayment risk. This risk's main drawback is that it might tilt the playing field against the investors.
When the expense account is due, there is a reverse prepayment entry where the prepaid expense account is credited, and the expense account is debited.
| Dr. Expense account | XXX | |
| Cr. Prepaid expense account | XXX |
Types of Prepayment
They are categorized into the following categories:
- Corporate: they are the advance payments made by the firm or the company for various purposes like paying advance rent for the lease, etc.
- Individual: several individuals also prefer making advance payments by prepaying their upcoming expenses like electricity.
- Tax-related: Many corporate taxpayers settle their tax debt before the deadline to qualify for the rebate.
It is supposed to bring benefits to the company in the future and hence claimed as a current asset in preparing the company's financial statements.Factors influencing such decisions are prepayment penalties, alternative investments, and alternative funding sources.
If the customer tends to repay the amount in full in the early stage of the loan or any debt, he saves a lot of interest.
Prepaid expenses are first listed as an asset on the balance sheet. The cost is subsequently recorded as an expense as and when the benefits of the assets are realized.
Some people have confusions about accrued and prepaid expenses being similar, but in reality, they are not. Accrued expenses are considered current liabilities and prepaid expenses are considered existing assets in the company's financial position statement.
A risk directly occurs with any prepayment the company makes for future debts and obligations or fixed-income assets. If the customers pay off all or a part of the mortgage, the lenders may charge the customers, which is a prepayment penalty in accounting terms.
For example, if a customer decides to pre-pay the two-year-old mortgage of $150,000 with a penalty of 5%, then the customer needs to pay $7500 as a charge for paying off the mortgage early.
Examples of prepayment entries
The following are specific examples.
1. ABC Ltd. has decided to pay the advance insurance of $50,000 for the upcoming 12 months (in the current accounting period).
Initial journal entry:
| Particulars | Debit | Credit |
|---|---|---|
| Dr. Prepaid Insurance a/c | 50,000 | |
| Cr. Cash a/c | 50,000 |
Adjusted journal entry when prepaid insurance expires:
| Particulars | Debit | Credit | |
|---|---|---|---|
| Dr. Insurance expense account a/c | 50,000 | ||
| Cr. Prepaid insurance a/c |
|
50,000 |
2. The Company ABC Ltd. decided to pre-pay the rent of $60,000 for the following year in the current accounting period.
Initial journal entry:
| Particulars | Debit | Credit |
|---|---|---|
| Dr. Prepaid Rent a/c | 60,000 | |
| Cr. Cash a/c | 60,000 |
Adjusted journal entry when prepaid rent expires:
| Particulars | Debit | Credit |
|---|---|---|
| Dr. Rent expense account a/c | 60,000 | |
| Cr. Prepaid Rent a/c | 60,000 |
3. ABC Ltd. paid the payroll for April 2020, which amounts to $25,000 in advance to the company employees. Represent this transaction in the journal entry.
Initial journal entry:
| Particulars | Debit | Credit |
|---|---|---|
| Dr. Prepaid salary a/c | 25,000 | |
| Cr. Cash a/c | 25,000 |
Adjusted journal entry when prepaid salary expires:
| Particulars | Debit | Credit |
|---|---|---|
| Dr. Salary expense account a/c | 25,000 | |
| Cr. Prepaid Salary a/c | 25,000 |
We are now representing these 3 example transactions in the balance sheet for the company ABC Ltd.
ABC Ltd.
Balance sheet for the year ended 31/03/2020
| Particulars | $ | |
|---|---|---|
| Assets - | ||
| Current assets: | ||
| Prepayments (note 1) | 135,000 |
NOTES TO ACCOUNTS:
Note 1: Prepayments
| Prepaid insurance | $50,000 |
| Prepaid rent | $60,000 |
| Prepaid salary | $25,000 |
| Total | $135,000 |
Prepayment FAQs
Yes, all the prepayments which are recorded at the beginning of the year need to be reversed at the end of the period.
These are recorded as current assets on the assets side in the balance sheet or the statement of financial position of the company.
The three major categories are corporate, tax-related, and individual prepayments.
The two methods of accounting for them are referred to as the asset method and the expense method.
No, they are not considered cash equivalents. They become a part of the current assets in the balance sheet or the financial position statement of the company.
Prepaid expenses reduce the cash flow of the company or reduce the liquid cash in the company.
These are located in the cash flow from operating activities section of the statement of cash flow of the company.
Some lenders levy a fee known as a prepayment penalty if you pay off all or a portion of your mortgage earlier than the due date mentioned in the agreement.
It refers to the risk associated with the early return of the principal on a fixed-income asset.
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