MANAGEMENT ACCOUNTS - 13.10.2010

Spreading the costs

What is a prepayment?

Legitimate matching. One of the fundamental accounting principles is “matching”. This means that, regardless of when you actually incur the cost, you should match the proportion of the expense to the accounting period it relates to. The remainder of the expense will relate to a future period and, therefore, should be carried forward as a “prepayment”. You should always use this principle when preparing your monthly management accounts - it will give a more accurate monthly profit figure, not distorted by a large annual expense payment that just happens to have been paid in a particular month.

Year-end. Typically, your company will have made a payment, part of which relates to a future accounting period. For example, if your company’s year-end is April 30 and you paid its quarterly rent on March 25 then only five weeks’ rent should be taken into account for the year ended April 30. The rent is for the 13 weeks to June 24 so 8/13th of the amount paid is a prepayment, i.e. it relates to the period after April 30.

There’s more. Other common examples of prepayments are insurance, maintenance contracts and business rates. Usually, the external accountant works out the prepayments at the year-end. However, to avoid having a large adjustment between your management accounts and the year-end accounts, you should consider calculating them on a monthly basis.

Monthly. Calculating a monthly prepayment is done in the same way as an annual one. You just work out the amount of the expense that relates to the period after the month-end.

How do you account for them?

Journal entry. At the end of the month, you need to do the following to add back the proportion of an expense that relates to a future period:

Debit: Prepayment (account code within debtors section on B/S)

Credit: Expense (P&L)

For example, on Sage, to enter a rent prepayment you debit the prepayments account (account 1103) and credit the rent account (account 7100).

Tip. If you prepare monthly accounts, you have to put through these journal entries and then reverse them in the following period.

Spreadsheet calculator

Monthly calculation. There will be extra work involved each month in recalculating prepayments. For example, your company will have a number of insurance policies with differing premiums and renewal dates so the monthly prepayment calculation could look like this:

Tip. See The next step for a spreadsheet to help you automate the work involved in calculating monthly prepayments.

For a prepayments calculator, visit http://financialcontroller.indicator.co.uk(FC 03.01.10).