Prepayment

What is Prepayment?

The term “prepayment” refers to any payment made before its due date. Typically, firms tend to make advance payments to cut down their financial burden, especially in the case of loans. This payment type is also used as a tool to access monetary benefits in the form of discounts, especially in the case of trading bills. Some of the most common prepayment examples are loan repayment, prepaid bills, salary, rent, insurance premium, income tax, sales tax, credit card bill, line of credit, etc.

How does prepayment work?

A prepayment is a financial tool by people who intend to make the most out of a payment obligation. In simple terms, prepayment is the early payment of the future liability. For instance, an insurer may choose to prepay the insurance premium, which will become due next year, or a firm may prepay its supplier well before receiving the consignment.

Besides adjustment of the accounting entries, the firms don’t face too much of a hassle with prepayments. Such payments are captured as current assets in the balance sheet. However, the parties participating in the transactions must agree to the arrangement; otherwise, there will be some prepayment penalties. Especially, many lenders charge a penalty if the borrowers decide to repay the loan, making the loan more expensive.

Examples of Prepayment

Let us look at the following examples to understand the concept of prepayment.

Example #1

ABC Inc. paid $24,000 in advance for the marketing and advertising service offered throughout the year. The company will initially charge the entire $24,000 to the prepaid expenses account on the balance sheet. Then it will charge $2,000 of it to the marketing and advertising expense account each subsequent month during the year so that the expense matches its usage. In this case, the prepaid expenses asset will be over by the end of the year.

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Example #2

David recently purchased an insurance policy wherein he is required to charge $500 per month. He has to pay for a minimum of 6 months of coverage, which he will have to pay $3,000 (= $500 x 6 months) to initiate the insurance service. The prepaid coverage will be captured as an asset in his balance sheet, and $500 will be deducted from that asset every month for the next six months.

Types of Prepayment

There are three main categories of prepayment – prepayments by corporates, prepayments by individuals, and prepayments by taxpayers.

1. Prepayments by Corporates

In this case, prepayments are mostly associated with expenses for goods and services. The firms usually pay these expenses in full in one accounting period for items consumed in the future. The prepayment is initially classified as a current asset in the balance sheet and then later reclassified as an expense in the income statement once the asset is consumed.

2. Prepayments by Individuals

Here the individuals make the advance payment, and the accounting process, in this case, is much easier. Examples of prepaid expenses include utility bills, loan installments, credit card bills, etc.

3. Prepayment by Taxpayers

Typically, taxpayers make a prepayment of their taxes wherein part of their pay is withheld for taxes. In the case of salaried employees, their employers withhold the taxes and pay them to the government on the employee’s behalf. On the other hand, self-employed individuals make the prepayment by filing quarterly taxes.

Accounting for Prepayment

It is important to understand the accounting for prepayments under the double-entry book-keeping system, wherein these payments affect both the balance sheet and the income statement. On the date of the advance payment, the accountant debits the prepaid expense account and credits the cash account. Suppose the service associated with the advance payment is likely to be availed of in the same accounting period. In that case, it won’t affect the balance sheet at the end of the accounting period. However, suppose the prepaid expense is incurred in the current accounting period, and the service will be available in the following period. In that case, it will appear as a current asset on the balance sheet for the current period.

Management of Prepayment

In a typical sales process, the buyer places the order for goods or services, and the supplier fulfills the order by shipping the same. First, an invoice is generated, then sent for payment, and then the payment occurs after the buyer receives the order. However, in some cases, the payment is made up-front in full well before receiving the goods or services. In such a scenario, the payment received by the supplier is known as prepayment.

Key Takeaways

Some of the key takeaways of the article are:

Prepayments refer to the payment of expenses well before their actual due date.
Firms usually make prepayments to cut down their financial burden, or it is used as a financial tool to get monetary benefits through discounts.
There are three types of prepayment – prepayments by corporates, prepayments by individuals, and prepayments by taxpayers.
On the date of the prepayment, the accountant debits the prepaid expense account and credits the cash account.

Conclusion

So, it can be seen that prepayment is a very useful tool that both corporates and individuals can use to reduce their financial burden and get monetary benefits. While the corporates need to take care of the accounting process, individuals don’t need to worry about accounting. So, overall, it can be a great financial tool if used wisely.

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