A prepayment is money paid now for something that belongs to a later period - an annual insurance premium or rent paid in advance. Until the period it covers arrives, it is treated as an asset rather than an expense.
What it means
Accrual accounting wants each period to carry only its own costs. If a business pays a year's insurance up front, charging it all to the month of payment would overstate that month's expense. Instead the prepayment sits as an asset and is released to expense month by month as the cover is used.
Where it fits in
Prepayments are the mirror image of accruals: an accrual recognises a cost before it is paid, a prepayment defers a cost already paid. Both exist to land each expense in the right period, which is the heart of the accrual basis.
Key rules
- An expense paid in advance, held as an asset.
- Released to expense over the periods it covers.
- The opposite of an accrual, which recognises cost before payment.
- Keeps each period carrying only its own costs.
