Many businesses make prepayments for various reasons throughout the year. A common example is prepayments made for insurance. So how do you properly record them in your books? While many taxpayers may be using the cash method of accounting we recommend businesses us the accrual method for their books and managing their business. As the name of prepayment suggests, it’s a payment to pay for future expenses, often referred to as a prepaid expense. For example, you pay $1,200 for liability insurance to cover the full year of 20X7 expense on 12/24/20X6. The expense isn’t actually incurred by your business before 20X7 which means you shouldn’t deduct this payment from income in 20X6. However you do still need to record the payment in your books, otherwise, your bank accounts can’t be reconciled. Therefore you would record the payment as an asset, prepaid expense.
Let’s illustrate the process using QuickBooks Online (QBO).
- Set up a prepaid expense account as an Other Current Asset account in the QBO chart of accounts.
- Record the vendor payment when made to the the prepaid expense account.
- Make a journal entry to your books monthly by following these four steps:
- Date the journal entry as 1/31/20X7
- Debit $100 ($1,200/12) as the monthly insurance expense
- Credit $100 to the prepaid expense account
- Set this journal entry as a recurring journal entry.
Now you are all set!