Just recently we received a question about prepayments. Now imagine a situation – you received a prepayment from your client (either invoiced separately or charged as extra to compensate on extra services (like commercial space etc.), but due to whatever reasons you were unable to provide the actual service during the period or at year end. This in result means that you essentially received the money, but you didn’t do what you promised for it.

Yes, to start off, it’s not a nice place to be in, but it happens. It’s life and it’s business. Now, as we said, be the reasons what they may, we have the accounting for it to worry about. Normally, when you receive prepayments from your clients (say a 100 in our example), you should account them as follows:

Debit – Cash and cash equivalents – 100
Credit – Prepayments received – 100

In all honesty, there is no other right way to account for prepayments. It’s definitely not income, not until you have actually provided the service or sold goods you promised.

However, what to do when you haven’t done the above and have accounted these prepayments as income? When this is the case, you should review the majority of the prepayments you have received and accrue a liability on your balance sheet. It would mean decreasing your income and increasing liabilities on your balance sheet at year end. When you have later on provided the service or sold goods, you can then account it as income.