Prepayment refers to paying off an expense or debt obligation before the due date. Often, companies make advance payments for expenses as well as goods and services to shed their financial burden. Advance payments also act as a tool to attain monetary benefits. Examples of prepayment include loan repayment before the due date, prepaid bills, rent, salary, insurance premium, credit card bill, income tax, sales tax, line of credit, etc.
- Prepayments are the payment of expenses or debt obligations ahead of the due date. It also includes the advance paymentAdvance PaymentAdvance payment is made by a buyer to the seller before the actual scheduled time of receiving the goods and services. It protects the seller from the risk of non-payment. Additionally, it helps sellers financially in the production of the goods or rendering of services. to vendors before the arrival of goods or services.
- They are not always rewarding, especially with debt repayments, as advance settlements result in loss of income to the lender. Therefore, the lender may impose a penalty for the early clearance of the debt amount.
- In accounting, a prepaid expense is recorded as assets until its due date, and then it is transferred to the respective expense account. The respective expense account will be a part of the expenditure or cost in the income statement.
How Does Prepayment Work?
Prepayments work as a financial tool for those who wish to make the best out of a payment obligation. In simple terms, it is an advance payment of an upcoming liability.
For example, George bought a crusher on loan. Although the repayment instalment wasn’t due for a year, he prepaid an instalment to save on the interest charged.
Apart from loan repayment, an insurer can prepay the insurance premium due next year. A business could pay its supplier before receiving the order. Some users prefer the prepayment of electric or gas meter to avoid disruptions.
Except for adjusting accounting entriesAccounting EntriesAccounting Entry is a summary of all the business transactions in the accounting books, including the debit & credit entry. It has 3 major types, i.e., Transaction Entry, Adjusting Entry, & Closing Entry. , businesses usually don’t face much hassle with advance payments as they are considered a current assetCurrent AssetCurrent assets refer to those short-term assets which can be efficiently utilized for business operations, sold for immediate cash or liquidated within a year. It comprises inventory, cash, cash equivalents, marketable securities, accounts receivable, etc.. However, the parties involved must agree to the arrangement; otherwise, there could be penalty charges. In debts, many lenders charge a penalty on prepayments which makes the loan more expensive.
Why Are Prepayments Preferred?
If utilized correctly, advance payments can greatly help manage one’s assets and liabilities. A business could bind a supplier to deliver the purchased goods by prepaying for the order.
If a supplier is short on cash, receiving an advance from the client could help materialize the order. In 2020, Iraq was reported to seek a five-year prepayment deal to gain some finance which was affected due to low oil prices. Iraq wanted to repay with its Basra crude oil.
In 2021, Iraq announced that it has decided to freeze the prepayment deal as oil prices were on the rise. An advance payment arrangement could have hindered from gaining out of the price rise. Similarly, if a business prepays an order which is expected to become highly expensive in future, it will lose less out of the price rise.
Sometimes, paying in advance avails a great deal or significant discounts on goods or services from the vendor. Many individuals and businesses decide to pay off their debts with surplus funds. It lowers the amount of interest charged on loan in addition to shedding their repayment burden faster.
Prepayment Accounting in Double Entry Bookkeeping
It is essential to understand the accounting of prepayments under double-entry bookkeeping. Advance payments affect the balance sheetBalance SheetA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company. and income statementIncome StatementThe income statement is one of the company's financial reports that summarizes all of the company's revenues and expenses over time in order to determine the company's profit or loss and measure its business activity over time based on user requirements.. Accountants usually record prepaid expenses or bills in the books of accounts in the following manner:
- Accountants debitDebitDebit is an entry in the books of accounts, which either increases the assets or decreases the liabilities. According to the double-entry system, the total debits should always be equal to the total credits. the prepaid expense account on the date of the advance payment and credit the cash or bank account.
- For example, an advance payment of salary will create a prepaid salary account on the debit side as it is an asset. The amount will be deducted from the bank account to be shown on the credit side.
- On the due date of salary, the company will make a journal entry for the paid salary account even if it has already been paid.
- The paid salary account will be debited against the prepaid salary account, which will be credited to balance the books. Also, the salary expense will be deducted as an expenditure while calculating the year’s loss or profit.
- If the prepaid expense is payable in the same accounting periodAccounting PeriodAccounting Period refers to the period in which all financial transactions are recorded and financial statements are prepared. This might be quarterly, semi-annually, or annually, depending on the period for which you want to create the financial statements to be presented to investors so that they can track and compare the company's overall performance., it won’t affect the balance sheet and income statement.
- However, if the prepaid expense was incurred in the previous accounting period, it will appear as an asset in the current accounting period’s balance sheet. The previous accounting period’s income statement will have a record of this prepaid expense.
Example with Journal Entry
Jay owns ABC Steel Plant. He took fire insurance with a yearly premium of $3000 on March 31, 2019. He prepaid 2020’s premium as well on March 31, 2019. On the due date, i.e., March 31 2020, the prepaid insurancePrepaid InsurancePrepaid Insurance is the unexpired amount of insurance premium paid by the company in an accounting period. This portion of unexpired insurance is an asset and will be shown in the balance sheet of the company. premium was transferred to the insurance premium expense. Let us see the journal entries made for accounting for this prepaid expense:
|31/03/2019||Prepaid Insurance Premium |
To Cash A/c
| 3000|| |
|31/03/2020||Insurance Premium |
To Prepaid Insurance Premium A/c
Types of Prepayment
People of different cadre make advance payments for various reasons. Companies, individuals and taxpayers equally resort to prepaid expenses for reducing their liabilities.
Let us understand the three main types of prepayments below:
- Corporate – Companies make advance payments for different purposes. For instance, they pay a year’s rent in advance as part of the lease. Firms prepay electricity bill to ensure continued supply. They also purchase stock for seasonal goods ahead of the season to escape paying the overcharged costs.
- Tax-related – Many corporate taxpayers pay their tax liability before the due date to enjoy the rebate. The companies also cut and retain the tax amount before releasing the employee’s salary under the law of TDS (Tax Deducted at Source), thus making advance payments on behalf of salaried taxpayers.
- Individual: Various individuals such as housewives and consumers also prepay their upcoming bills, expenditures or loan instalments. Individuals use this tactic to get rid of debt and lower the accumulating interest on the borrowed amount.
Some debts come with the risk of prepayment penaltiesPrepayment PenaltiesThe prepayment clause states that if payment is made in advance before the due date, then terms and conditions of the mortgage are not adhered to by the borrower and would be liable to pay the penalty known as the prepayment penalty. since the lender makes less interest if the principal is repaid sooner. A penalty here is a fee that a borrower needs to pay when making an advance loan settlement.
It serves to discourage advance settlements by making the debt more expensive to the debtorDebtorA debtor is a person or entity that owes money to the other party in a transaction. The receiver is referred to as the creditor, and the payment terms vary for each transaction based on the terms and conditions agreed upon by the parties.. Mortgage debts or student debts usually don’t contain the risk of a prepayment penalty.
Moreover, many lenders do not penalize debtors who pay from their pocket. However, they may attract penalties if the repayment amount has come off refinancingRefinancingRefinancing is defined as taking a new debt obligation in exchange for an ongoing debt obligation. In other words, it is merely an act of replacing an ongoing debt obligation with a further debt obligation concerning specific terms and conditions like interest rates tenure.. Usually, the penalty fee is 2% or beyond, and the lender charges it on the outstanding principal amount. Apart from your banker, there are several books and prepayment mortgage calculators in the market to help calculate the fee amount.
In case of expenses or purchases, there lies a risk of not fulfilling the contractual obligations by the other party. Although the organization can file a suit against such a defaulter party, it could potentially lose to non-compliance.
As such, a company’s advance payment decision considers the availability of surplus cash, terms of the contract, upcoming project expenses, business cash flow, sales and purchase turnover cycles, etc.
To record the prepaid expenses in the books of accounts, we pass adjusting journal entries. Initially, we debit the prepaid expense account and credit the cash account.
Prepayments in the balance sheet appear as an asset and recorded as a prepaid expense in the income statement. On the due date, the related expense account is created and put on the debit side while we credit the prepaid expense account.
They are recorded as assets under the name of the prepaid expense account in the balance sheet.
Yes, when the expense account is due, the prepaid expense account is credited, and the expense account is debited. It will shift the focus from the prepayment in the accounting books to the actual expense account.
One of the most common prepayment examples is paying off the principal amount of a loan ahead of its due date. Another instance is making advance payment for a consignment of goods in progress and deliverable after two months.
This has been a guide to what is prepayments and its definition. Here we discuss types, examples, and uses of prepayments along with advantages and disadvantages. You can learn more about financing from the following articles –