What is Prepayments?
Prepayments are expenses you've paid in advance for something you'll receive in the future. They're assets until the benefit is received.
Example
Pay £1,200 annual insurance in January. Each month, £100 moves from prepayment (asset) to expense.
Key Dates
Calculate at year end for accurate accounts
How Prepayments Works in Practice
Prepayments arise when your company pays for goods or services before the benefit is fully received. In accounting terms, a prepayment is classified as a current asset on your balance sheet because it represents a future economic benefit your company has already paid for.
The most common examples include annual insurance premiums paid upfront, rent paid in advance, software subscriptions covering future months, and professional memberships renewed at the start of the year. When you pay £1,200 for a 12-month insurance policy in April, only the portion relating to the current accounting period counts as an expense. The remaining months are a prepayment.
Under the accruals basis of accounting (which all UK limited companies must use under FRS 102 or FRS 105), expenses must be recognised in the period they relate to, not when cash changes hands. This is called the matching principle. Without adjusting for prepayments, your profit and loss statement would overstate expenses in the period of payment and understate them in future periods.
At your year end, you or your accountant will review all payments to identify any that cover periods beyond the accounting date. These amounts are moved from the expense line to the balance sheet as a current asset. In the next period, the prepayment is released back to expenses as the benefit is consumed. This ensures each accounting period bears only the costs that genuinely relate to it.
Step by Step
When your company makes a payment that covers a future period, you initially record the full amount as a prepayment (a current asset on the balance sheet) rather than an expense. Each month or period, the portion of the prepayment that has been 'used up' is transferred from the balance sheet to the profit and loss account as an expense.
For example, if you pay £6,000 for six months of rent on 1 January and your year end is 31 March, three months of rent (£3,000) is an expense in your current year accounts. The remaining £3,000 for April to June sits as a prepayment on your balance sheet. Your accounting software can automate this with scheduled journal entries, or your accountant will post the adjustment as part of the year-end process.
The key test is whether the payment crosses your accounting period boundary. If you pay for something entirely within the current period, there is no prepayment to record. Only the portion extending beyond your year end needs adjustment.
Practical Tips
- Keep a prepayments schedule listing every advance payment, its total amount, the period it covers, and the monthly release amount - this makes year-end adjustments straightforward
- Set calendar reminders for annual renewals so you can budget for large prepayments like insurance, software licences, and professional memberships
- Ask your accountant about materiality thresholds - many small companies only adjust prepayments above a certain value (e.g. £500) to save time
- If using accounting software like Xero or QuickBooks, use the prepayment feature or scheduled journal entries to automate the monthly release
Common Mistakes to Avoid
- Forgetting to reverse prepayments at the start of the next accounting period, which leads to expenses being understated in the following year
- Treating one-off payments that fall entirely within the accounting period as prepayments when no adjustment is needed
- Failing to identify all prepayments at year end, particularly smaller items like domain renewals, annual software licences, and professional subscriptions
- Not distinguishing between prepayments (current assets) and deposits paid (which may be non-refundable and should be expensed immediately)
Frequently Asked Questions
What is the difference between prepayments and accruals?
Prepayments are amounts you have paid but not yet consumed the benefit of, so they appear as assets. Accruals are the opposite: expenses you have incurred but not yet paid for, so they appear as liabilities. Both adjustments exist to ensure your accounts accurately reflect the period's true costs.
Do I need to record prepayments for small amounts?
Technically yes, but most accountants apply a materiality threshold. If the amount is trivial relative to your overall accounts, it may not be worth adjusting. For micro-entities filing under FRS 105, the thresholds are more relaxed, but material prepayments should always be recorded.
Where do prepayments appear on the balance sheet?
Prepayments sit under current assets on your balance sheet, typically grouped with other debtors. They represent cash already spent that will benefit future periods. At the next period end, the consumed portion moves to the profit and loss account.
Can prepayments affect my Corporation Tax bill?
Yes. By correctly recording prepayments, you ensure only the expenses relating to the current accounting period reduce your taxable profit. If you expense an annual payment entirely in one period, you may understate profit in the following period and overstate it in the current one.
How do prepayments work with VAT?
You typically reclaim VAT on the full invoice when you receive it, regardless of the prepayment treatment. The prepayment adjustment is an accounting entry only and does not affect when you recover input VAT on your VAT return.
Source: HMRC Business Income Manual BIM46500 - Accruals basis: general principles
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