A prepayment is an accounting adjustment made for costs that have been billed or paid for in one accounting period but relate to another.
Accounts are prepared using the matching principle whereby revenue for a specific period must be matched with all the related costs for that period.
If you receive a bill in one financial year but it relates to costs for a future financial period, then an element of this bill will be classified as a prepayment.
An Example of a Prepayment
ABC Limited has a financial year end of 31 December 2017. In March 2017, ABC Limited receives its annual Business Rates Bill covering the year 1 April 2017 to 31 March 2018 for £4,200 (£350 per month).
In the financial statements for the year end 31 December 2017 3 months of Business Rates for January 2018 to March 2018 will be shown as a prepayment of £1,050 (3 x £350).
Journal Entry for a Prepayment
The journal entry for the prepayment of Business Rates in the above example would be:
Dr Prepayments £350
Cr Rates £350
This journal entry would need to be reversed either in the accounts for the year end 31 December 2018 or if you prepare monthly management accounts, it could be reversed in three entries dated January, February and March.
If your business is VAT registered then prepayment adjustments are made net of VAT.
The Effect on Your Financial Statements
A prepayment reduces costs in the profit and loss account and so increases profit and shareholders funds.