What is a prepayment? And why does my accountant use accounting journals to record these?

A ‘prepayment’ adjustment is made in your accounts when your business makes a payment in advance, but the benefit of the goods/services purchased is received in a later period.

By adjusting the accounts, it ensures that the expenses are allocated to the period your business ‘consumes’ the goods or service.

This helps to spread costs evenly over your financial year so you get a more realistic picture of your monthly profits.

You may hear your accountant or bookkeeper mention making a ‘journal entry’ to reflect the prepayment. A journal entry is a physical entry within your accounting software usually made by your accountant.

A prepayment is shown in your business Balance Sheet as a current asset.

When the expense is consumed/benefit taken, it is released from the Balance Sheet into your Profit and Loss account.

Working example:

Subscriptions are often a cost that are paid annually in advance.

If you pay in January for a subscription that lasts to December and the cost paid upfront is £1,200, then you are paying £100 per month.

Your accountant or bookkeeper should make an adjustment in the appropriate accounting journal to spread this cost over the year.

The prepayments in your Balance Sheet will start in January at £1,100 and £100 of the cost will be in the January subscriptions expense in your Profit and Loss account.

Each month £100 is taken to the Profit and Loss and the prepayment is reduced until the last £100 is released to the P&L in December and the prepayment is then Nil.

The definition of an accrual.