What do prepayments refer to in accounting?

Prepayments in accounting refer specifically to payments made in advance for goods or services that will be received in the future. This concept is fundamental in accrual accounting, where expenses are recognized when they are incurred, not necessarily when they are paid.

When a business makes a prepayment, it records the transaction as an asset on the balance sheet until the goods or services are received, at which point the asset is expensed. This ensures that the financial statements accurately reflect the expenses in the period in which the related benefits are realized. This practice helps maintain the matching principle, which aligns revenues with the expenses incurred to generate those revenues within the same accounting period.

Other options do not accurately capture the definition of prepayments. Payments made at the time of receipt imply a cash transaction rather than an advance payment. Overdue payments refer to past-due amounts and do not pertain to prepayments. Settling debts relates to liabilities, not the advance payment for future goods or services. Hence, the definition of prepayments is clearly best represented by advance payments.