Accounting for Prepayments
Prepayments are the payments that the selling companies have received from their buyers before they deliver the products or provide the services to their buyers. Three situations cause prepayments to happen:
- the buyer uses the cash basis to record its business transactions and wishes to record the expense early, so it pays the seller early
- the seller does not want to extend credit to its buyer
- the buyer wants the seller to give them a priority for an order
We will look into accounting for prepayments from the seller’s and the buyer’s perspectives:
- From the seller’s perspective, it will record the prepayment by debiting its cash account and crediting its liability account for prepayment (Also see Accounting – Understanding Credit and Debit in the Business). When it has delivered the products that the client has ordered, it will debit the prepayment account and credit the revenue account related to that deal. Typically, the seller will not receive prepayments often, and therefore it can track those amounts easily.
- From the buyer’s perspective, it will record the prepayment by debiting its prepaid expense account and crediting its cash account. When it has consumed the prepaid expense fully, it should debit an expense account related to that transaction and credit the prepaid expense account. In some cases, the buyers may overuse their prepaid expense accounts, and thus, they need to keep track of a lot of small prepaid items. To avoid such a situation from happening, they should only use the prepaid expense accounts if the amount of prepayment is greater than a fixed threshold amount. For all other expenses, they should charge them to expenses although they have not yet consumed the items entirely.
To put it simply, sellers will record prepayments as liabilities, while buyers will record them as assets. Typically, they will categorise these items as their current liabilities and current assets, respectively. This is because generally, there is an expectation of consuming these items in a year in the balance sheet of both the seller and the buyer.
As an instance, XYZ Corporation pays RM18,000 ahead of time for a lawn mowing service which lasts for a year. To record this transaction, it will charge the full amount to its prepaid expense account initially. Then, every month it will charge RM1,500 of the total amount to the related expense account in the next 12 months. This is to show that it is using the expense. At the end of the year, the prepaid expense, which is an asset, will be eliminated.
In the next year, XYZ Corporation, which makes television advertisements, receives an advance payment of RM6,000 from its client. It has to advertise for the client for six months. To record this transaction, it will record the full amount that it has received as a liability. Then, in the next six months, it will transfer RM1,000 per month into its revenue account.
If you are not sure about how you should do the accounts for prepayments, you may consider engaging an accounting firm in Johor Bahru. By doing so, you can ensure that all the accounting records are correct and you do not have to worry that the financial statements cannot present the financial position of your company accurately. Most importantly, you will have more time to focus on your core business activities so that your company can continue growing.