Let’s suppose that Business A has entered into a maintenance contract with Business B to keep the computers of Business B in working order. The contract was started on 1st November, Business B paid £1,200 cash up front, and both companies have a year end of 31st December.
The accounts of Business B apparently show an expense of £1,200. However, only £200 of this relates to the current year for the period 1st November to 31st December. The other £1,000 relates to next year, and in the accounts of this year, it will be shown as a type of debtor called a “prepayment”. In next year’s accounts, this debtor on the balance sheet will be transferred to the equipment maintenance heading in the profit and loss account so it is dealt with correctly.
Prepayments are quite common in business accounts for things like rates, electricity, insurance, burglar alarm maintenance contracts, and so on. If the accountant of Business B accidentally overlooked the prepayment, then the profit this year would be understated by £1,000. This gives a little scope for interpretation, or subjective opinion, because it is not always obvious that there is an element of prepayment in an expense.
Now what happens in the accounts of Business A? What should happen, in mirror image fashion, is that £200 is recognised as sales or services income this year, and £1,000 is placed on the balance sheet as a type of creditor called “deferred income”. In the following year, this deferred income creditor is transferred to current sales in the profit and loss account so the future sale is recognised correctly.
Deferred income is a much rarer item in business accounts, and it is easy to overlook. If it is treated incorrectly, then there could be an overstatement of profit this year of £1,000 in the accounts of Business A. This may impress investors or the bank manager, but it also means that more tax has to be paid up front.
Where deferred income needs to be dealt with, a note in the accounting policies is advisable to say what is happening. Many accountants will use a checklist to remind them about items like deferred income, and this is also recommended.
The general thrust of accounting for prepayments and deferred income is that profits tend to be smoothed from year to year, which usually reflects the underlying activity of the business, and there should be less questioning from accounts users. Prepayments and deferred income may look like just a timing difference, but their correct treatment is advisable.