This article explains what prepayments are and how to post them in FreeAgent.
Definition of a prepayment
Under UK accounting rules, you need to put costs that your business incurs into your profit and loss account at the point when the business uses what it's paid for - which is not necessarily the same as when the cost was paid.
Often you'll pay costs such as rent and insurance in advance. For example, you might pay your business's home office insurance of £600 on 1st June 2020, and then you'll be covered for the whole year after that, up to 31st May 2021.
But if your business prepares accounts to 31st March each year, then if you just include your insurance in your accounts at the point when you pay for it, you'll have two months' worth of cost, £100, in the wrong year, and therefore your profit will be too low, because part of your insurance payment relates to April and May 2021.
So you need to take the £100, two months' worth of your insurance, out of your profit and loss account as at 31st March 2021.
This is called a prepayment.
Some larger businesses post monthly prepayments, but in smaller businesses it's more common to post them each year.
The £100 belongs in the year to 31st March 2022, so you'll then need to make sure you post it back to the profit and loss account for that year. Accountants call this "reversing" the prepayment.
In the above example, I would post two entries for the original prepayment of £100, dated 31st March 2021, to debit code 620 Prepayments, and credit the code where the original cost went, in this case code 364 Insurance.
How to reverse the prepayment
To reverse the prepayment, post another pair of journal entries for the same amount, dated the first day of your business's new accounting year, in this case 1st April 2021.
These would be the reverse of the first pair, in other words, credit code 620 Prepayments, and debit the code where the cost belongs, in this case code 364 Insurance.
Inclusive or exclusive of VAT?
When you work out a prepayment, use the VAT exclusive figure from your bill. (Insurance is exempt from VAT anyway.)
This is unless you're on the VAT Flat Rate Scheme, in which case you should use the bill figure including VAT.
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