Definition: A prepayment is the sum paid for goods or services before their receipt or invoiced due date. In other words, a company has ordered and paid for goods or services but has not received anything yet.
What does Prepayment Mean?
What is the definition of prepayment? For the most part, products or services are paid for after they have been acquired. For example, a contractor would be paid for their services after the work has been performed. This arrangement ensures that they complete the project and do not leave the job unfinished.
However, some services are paid in advance. Two common examples of a prepaid expense are insurance and rent. In both instances, payments are made at the beginning of the coverage period. With rent, payments are usually made at the beginning of the month and cover use of the property for that month. For insurance, people and businesses make payments for coverage that extends for some period of time after the payment is made i.e. coverage for 6 – 12 months.
It is important to distinguish prepaid expenses in business to make sure that they are properly accounted for. When a company prepays for an expense, they can account for the future use of that service by listing it as an asset on their balance sheet. Then as each month passes, they can deduct the used portion from the asset. This accounting method can be an important way for the company to properly distribute the cost of the prepaid service across the term of its use and more accurately reflect the expenses it incurs for each period.
Example
Using insurance as an example, if an insurer charges $600 per month and requires customers to pay for a minimum of 6 months of coverage, the customer would pay $3,600 ($600 x 6 months) to start the service. The prepaid coverage would then be listed as an asset on the company’s balance sheet and $600 would be deducted from the asset each month until the 6-month period is complete.
Summary Definition
Define Prepayments: Prepayment means an obligation has been paid for in advance of its due date or corresponding goods being recieved.
