Imagine a scenario (maybe a real situation for your company already or may be just happening ahead) – you are required to do an advance payment for some goods that you will be holding for sale when they arrive. They will essentially form a part of your inventory.

One part of the accounting entry is obviously Cr Cash as you give away money, but in return you get the right to retrieve assets. You have made a prepayment for it and as such it should be recognized as a part of assets on the balance sheet.

When you make prepayments for future expenses, they are recognized as prepaid expenses on a separate line under current assets on the balance sheet. However, when you make an advance payments for inventory, those payments done are recognized as a separate financial statement line item, but as a part of inventory (the entry is as follows: Dr Prepaid for inventory, Cr Cash). This way you will clearly show how much inventory your company in reality possesses.

When this inventory is received, you make the following entry: Dr Goods held for sale (or any other inventory group you bought the goods or materials for) and Cr Prepaid for inventory. This accounting entry is now done within the inventory group on the balance sheet and does not affect the inventory balance.

Treating prepayments done for inventory as a part of inventory group gives the readers and consumers of your company’s financial statements a better view of the real inventory levels. As inventory also affects couple of financial ratios, it is necessary to keep all prepayments done for goods or materials within inventory group on the balance sheet.