Consider a trader who makes up accounts annually to 30 June.
On 1 March 2007 he moves to a new property and pays the rent of £1,200 for a year in advance. Year to 30 June 2007: The payment of £1,200 is recorded in this year. Clearly, however, it does not all relate to this year. It should therefore not all appear as an expense in the profit and loss account. We will split the payment into the portion that belongs to the year to 30/06/07 and the portion that belongs to the following year.
[{m}.{s}a]
We can see clearly that of the year covered by the rent payment 4 months fall in the accounts year to 30/06/07, the remaining 8 months being in the following year. Thus:
The amount of the prepayment £800 is deducted from the total paid (and therefore recorded in the Rent account) £1,200 to give the expense for the year £400.
Consider the original recording of the rent payment: We want to reduce the rent figure by £800 - how do we do this?
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[{m}.{s}b]
We must credit the Rent account (to decrease the expense).
This is double entry - so where do we make a debit? We have no existing account that we can possibly debit, so we must open a new one - the Prepayments account.
Therefore our adjustment to record the prepayment becomes:
[{m}.{s}c]
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[{m}.{s}d]
When we prepare the profit and loss account it is the balance of £400 in the Rent account that is transferred and appears as the rent expense:
[{m}.{s}e]
{m}.{s}.4 The Prepayments account is an asset account. As the trader has paid the rent in advance he has effectively bought an "asset" - the right to occupy the building for the next 8 months.
{m}.{s}.5 The balance in the Prepayments account is, therefore, included in the balance sheet - as a current asset (the asset is of short-term life). It is usually entered after Debtors. For example:
[{m}.{s}f]