Company balance sheets report the balances of various types of asset, liability and equity accounts at the end of the fiscal year. A balance sheet will always include prepayment accounts, but their classification as an asset or a liability depends on whether the company makes or receives the prepayment. The initial classification of a prepayment is temporary, since at some point the company will either provide or receive something that requires final classification as revenue or an expense.
Prepaid Asset Accounts
The company reporting its financial information on a balance sheet will include all prepayments of expenses and asset purchases it makes as an asset on the balance sheet. For example, suppose a company decides to prepay a vendor for an equipment order it places in the 2011 fiscal year, but will not receive it until the 2012 fiscal year. At the time it prepays the invoice, the company prepares a journal entry to insure the balance sheet accurately reflects the transaction. This requires a debit entry to a "prepaid equipment" account and a corresponding credit entry to the cash account. As a result, the 2011 balance sheet will report a decrease in the cash balance, but an increase in prepaid assets.
Prepaid Asset Adjustments
When the vendor delivers the equipment and the company accepts the shipment, a second journal entry is necessary to eliminate the balance in the prepaid equipment account. The appropriate journal entry requires a debit entry to an equipment asset account and a credit entry to the prepaid equipment account. Since this entry doesn't occur until the 2012 fiscal year, the company will not report the acquisition of the equipment until it prepares the 2012 balance sheet.
Prepaid Liability Accounts
Companies can also be in a position where they are on the receiving end of the prepayment from its customers. To illustrate, suppose the reporting company is the vendor selling the equipment and receives a prepayment for the order before delivery occurs. Accountants must still prepare journal entries for the balance sheet to reflect this new liability. Pursuant to financial accounting rules, companies cannot report revenue until they earn it. And when a company promises to deliver goods to a customer, it doesn't earn the revenue until it delivers. As a result, a debit entry is made to the cash account to reflect the inflow of cash and a credit entry is made to a liability account, such as deferred revenue.
Prepaid Liability Adjustments
When the company delivers the equipment, it can properly report the prepayment as revenue. It does this by reducing the deferred revenue account with a debit entry in the amount of the prepayment and a corresponding credit entry to its revenue account. Moreover, the balance sheet that covers the fiscal year in which delivery takes place will reflect the reduction in liabilities and the income statement will include the revenue.
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