Prepayments – What are prepayments?
Prepayments are amounts paid for by a business in advance of the goods or services being received later on. Any payment made in advance can be considered a prepayment.
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A prepayment is not dissimilar to a deposit but generally falls under a more set time period for fulfilment of the goods or services purchased. A deposit is also generally a part of the total amount, while a prepayment usually covers the full cost.
In the traditional sales process, goods or services are ordered and fulfilled. An invoice is then sent for payment, meaning the payment occurs after the order is completed to ensure the goods are sent or are as expected.
However, some types of goods or services require up-front payment in full before the goods or services are provided. In this case, the payment is known as a prepayment.
Some common expenses are also prepaid. Insurance is a regular example of an expense that requires prepayment due to the nature of the service.
Goods and services can be prepaid. If they have not been received by the end of the financial year, then the amount prepaid will appear in the balance sheet as prepayments and not as costs in the profit and loss account.
This amount will be subtracted from the balance sheet and added to the costs of the P&L. This way, the costs involved will be charged to the correct accounting period.
Depending on your business, you might find that you regularly work with prepayments. The two types of accounting systems handle payments differently. This affects when the expense/income is recorded in the financial records of a business.
When using the cash accounting system, you would record the payment as soon as it’s made. For example, payment for an expense is registered in the period in which the payment occurs, no matter when the service or goods are actually received.
In accrual accounting, payments are recorded when the financial event occurs, not when the cash actually changes hands. In this system, a prepayment for an expense would be entered when the invoice is issued, not when the payment is made.