A prepayment is a balance sheet caption that represents an expense that has been paid up-front. It is an asset on the balance sheet and unwinds as the benefit of the prepaid services is received. This concept only exists within accruals based accounting and seeks to align expenses to the period to which they relate.
Simplifying the definition; prepayments arise where payments are made in advance for services where the benefit is received over a period of time.
Prepayments are typically seen within current assets, though can also be classified within non-current assets if the prepaid period exceeds 12 months (i.e. where the future benefit is not expected to be received within one year from the date of reporting).
Cash based accounting
Under cash based accounting, the expense would fully be recognised in the period in which the payment occurs and therefore a prepayment would never arise. The double entry in this case would be Cr Cash (to reduce cash on balance sheet) and Dr Expense (to fully recognise the expense upfront).
Accruals based accounting
Using accruals based accounting, we seek to recognise the expense in the period to which it actually relates. For instance, let’s assume that a payment of £150 was made on 1st December 20XX for a three month advertising contract due to start on 1st December 20XX and end on 28th February 20XX.
Example double entry – debits and credits
When the payment is first made (on 1st December), the journal posting would be:
- Cr Cash 150 (to reflect the fact that cash has left the bank account)
- Dr Prepayment 150 (to create a prepayment; reflecting the fact that the future benefit of the advertising contract is an asset that is yet to be received)
At the end of December, one third of the advertising contract has completed (i.e. we have received one third of the benefit). As a result, one third of the prepayment should be released and expensed in the P&L.
- Cr Prepayment 50 (to release part of the prepayment; reflecting the fact that we have now received the benefit of 1 months advertising)
- Dr Expense (to record the expense within the P&L in the December month)
The same posting would then be made at the end of January and February by which point the prepayment will be fully released from the balance sheet.
How the prepayments balance is audited
The ultimate output of an audit is to certify that the accounts are free from material misstatement. In order to provide such a statement; each account balance must be tested for accuracy. It would be impossible to test all prepayments made by a company at the accounting year end, particularly in large companies which process many thousands of payments.
Therefore, auditors look to ensure that they get appropriate coverage of the prepayments balance to enable them to gain comfort that there are no material errors. In order to do this; the auditors may select particularly large prepayments manually if this would provide appropriate coverage, or they may select a randomised sample (potentially utilising software). The ultimate methodology will depend on the size of the business and the audit firm involved.
Regardless of the sampling methodology chosen; the auditors will then want to see evidence of payment and a copy of the relevant invoices for the sample chosen in order to ascertain whether the appropriate prepayment has been made. For instance, if the invoice relates to a three month advertising contract but the prepayment has been setup to release over five months; the auditors would pick this up and record as an error.
What to consider from a due diligence perspective
Prepayments sit within reported net working capital. When looking at the prepayments balance in a transaction services context; you should look to consider:
- Does the prepayments balance contain any non-trading items?