What are prepayments?

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Prepayments (also called prepaid expenses) are payments made in the current period for goods or services that will be consumed or received in a future period. Under accrual accounting, they are recorded as assets on the balance sheet — the business has paid for something it has not yet received — and expensed over the period in which the benefit is received.

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Common examples include annual insurance premiums, annual software licences, rent paid in advance, and retainers for professional services.

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Why prepayments matter at close

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At period end, the balance sheet prepayments account must reflect only the portion of advance payments that relate to future periods. The portion that relates to the current period has been consumed and must be expensed. If prepayments are not amortised correctly, expenses are understated in the current period and the balance sheet carries inflated assets.

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How prepayments are managed

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On payment. When an advance payment is made, it is recorded as a prepayment asset rather than an immediate expense. For example: paying $120,000 for a one-year insurance policy results in a $120,000 prepayment asset.

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Monthly amortisation. Each month, one-twelfth of the annual premium ($10,000) is transferred from prepayments to insurance expense via a journal entry.

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Schedule maintenance. A prepayments schedule lists every open prepayment, its total amount, its start and end dates, and the monthly amortisation. This schedule is reconciled to the GL prepayments account at each period end.

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Related: Accruals management · Balance sheet reconciliation · Journal entry · Month-end close