A prepayment is made when a selling company receives payment from a buyer before the seller has shipped goods or provided services to the buyer. Prepayment can happen under three circumstances:
A buyer wants preferred treatment for an order
The seller refuses to extend credit to a buyer
Accounting for Prepayments
We will address the accounting for prepayments from the perspectives of both the buyer and the seller.
Buyer perspective. From the perspective of the buyer, a prepayment is recorded as a debit to the prepaid expenses account and a credit to the cash account. When the prepaid item is eventually consumed, a relevant expense account is debited and the prepaid expenses account is credited. Buyers can overuse the prepaid expenses account, which results in the tracking of a large number of small prepaid items. To avoid the expense of tracking too many items, prepayment accounting should only be used if a prepayment exceeds a certain minimum threshold amount; all other expenditures should be charged to expense, even if they have not yet been consumed.
Seller perspective. From the perspective of the seller, a prepayment is recorded as a credit to a liability account for prepayments, and a debit to the cash account. When the prepaid customer order is eventually shipped, the prepayment account is debited and the relevant revenue account is credited. There tend to be few prepayments, so these items are relatively easily tracked.
In short, a prepayment is recorded as an asset by a buyer, and as a liability by a seller. These items are usually stated as current assets and current liabilities, respectively, in the balance sheet of each party, since they are generally resolved within one year.
For example, a company pays $12,000 in advance for Internet advertising that will extend through a full year. The company initially charges the entire amount to the prepaid expenses account, and then charges $1,000 of it to the advertising expense account in each subsequent month, to reflect its usage of the expenditure. The prepaid expense asset is eliminated by the end of the year.
As another example, a snow plowing company receives a $10,000 advance payment from a customer in exchange for plowing its parking lot in each of the next four months. The plowing company initially records the receipt as a liability, and then ratably shifts the amount into a revenue account at the rate of $2,500 per month in each of the next four months.