Advance payment is making a certain payment earlier than is usual such as paying for a particular good or service while the actual receipt will occur at a later date.
Prepayment can be acceptable to sellers as security for payment, or to cover the cost incurred by the seller in delivering the service or good.
As we know, there are numerous instances, where advance payments are necessary. Loan seekers with poor credit score often have to make upfront payments to the companies as do insurance companies who give an insurance cover to an insured person.
Key Takeaways
- Prepayments are made before they actually obtain the actual product or service.
- In many cases advance payments ensures the seller from any losses in the event the buyer does not pay on the delivery dates.
- Customers make advance payments to companies and on the balance sheet, the companies book the amount as an asset.
- An advance payment may include the purchase of a prepaid cell phone.
Understanding Advance Payments
M1: Prepayments are sums that are paid prior to receipt of a good or service. Any balance outstanding is then paid after delivery has been affected.
Such types of payments are different from deferred payments or payments due.
Here, the point is that the buyer receives goods or services and pays for it only after quite some time, or never at all. For instance, an employee who is paid after completing a month’s work, that is, paid at the end of the month, is paid a deferred payment.
That is why advance payments are reflected on the balance sheet in the component of the current assets section.
These are special assets and as they are utilized, they are consumed and taken to the income statement of the period of consumption.
The payments are usually made in two circumstances. These rates can be charged on an advance sum of money given prior to a contractual agreed date or may be charged before receipt of the goods or service required.
Advance Payment Guarantees
An advance payment guarantee is basically an insurance instrument, whereby the seller provides an inducement to the buyer that in the event that the buyer delivers the amount of advance payment,
And in the event that the seller fails to perform the agreed obligations in the form of supplying goods or services, then the amount of advance payment shall be returned to the buyer.
This protection enables a buyer to nominate a contract as ‘frustrated’, if the seller has not fulfilled his obligations, thus establishing the buyer’s right to the ‘paid’ amount.
Special Considerations: Advance Payments to Suppliers
In corporate business} A firm is often faced with early maturity of contracts where by large quantities being ordered by the firm are costly to the producer and hence the producer has to make early payments.
This is especially the case where the buyer resolves to rescind before the delivery of the goods is made.
Cornell Law School. “Advance.”
Presales help producers who might lack the capital to purchase the necessary materials to complete a large order and can apply part of the money received to go toward the creation of the product.
It can also act as a guarantee as to a particular level of revenue generation, once the large order is produced. If a corporation is in a position to make an advance payment, it reveals it in the balance sheet under the accrual method as prepaid expenses.
Examples of Advance Payments
It is now possible to observe numerous examples of using advance payments in reality. For instance, let us consider the prepaid cell phones.
This is because participants that offer service in the cellular market Crest require payment for services that the customer intends to use one month later.
With regards to whether or not an advance payment is made, the service is not going to be delivered. The same applies to expenditures for rent or utilities to be paid before the actual due times specified in the agreement.
Another example comes with citizen U.S which are eligible taxpayers that received advance payments through the premium tax credit (PTC) which is a policy of the Affordable care act (ACA).
Cohorts that qualify for the household income receive financial assistance to enable them cater for the health insurance rates.
The amount which should be returned to the taxpayer is provided to the insurance company prior to the due date for the credit.
Entry In Accounting
Beyond any doubt, advance tax can be a profitable way of doing business for both the buyer and the seller parties. But it is equally crucial to understand its accounting too.
We should now learn how advance payment tax and other entries may be made in the accounts of both the buyer and the seller.
For Buyer
When a buyer makes an ad-Vance to the seller to cover the cost of goods, the following entry needs to be made: We post the seller account with the debit balance as current asset in the buyer’s books of accounts until the buyer received the goods or services and issued the invoice.
For Seller
In other words, for an advance to be recorded, the seller has to depreciated the cash/bank account while crediting the buyer’s account.
Credit balance of buyer account: This increase current liability. Once the customer gets the needful goods or services which he paid for, it is the duty of the seller or the particular institution to send an invoice to the customer.
Added to the line is the total amount that is owed after having deducted it. Once completing this procedure, the institution or seller has to record the following transactions in the books of accounts:
Importance of advance payment
Let us understand the importance of advance payment solutions with the help of the discussion below.
Protection to the Seller: Advance payment removes the risk of daisy and credit risk that involves dealing with the buyer that has a low credit rating.
Provides Financial Assistance: Can cover some costs of the seller in making those goods.
Trust Builds Up: It means that trust is one of the most important and sensitive factors that are rather hard to establish in the business and what is more, after the getting of the prepayment even for the nonrefundable deals, the trust between the buyer and the seller is built.
Guarantee to the Buyer: The guarantee serves to ensure the buyer that if the seller fails as per its promise to do so, the seller will return the prepayments into the customer’s account.
FAQ’s
Why are advance payments regarded as liabilities?
From the seller side, advance payments mean an undertaking to provide goods or services at a repeated time in the future. So long as the obligation has not been met the amount received is accounted for as a liability.
Is cash received as a prepayment included in the revenue?
Hence, advance receipts are not the same as revenues, since the basic obligation, the completion of which entitles the seller to receive payment, has not been met by the buyer. Only then do they receive the label of ‘revenue’.
What do people generally consider as advance payments?
Rent payments made in advance
Prepaid insurance premiums
Monies in bank for construction related projects
The fees that are charged to subscribers at one go
Who makes use of advance payments more frequently – Which industries utilize it frequently?
Industries that frequently use advance payments include:
Real estate
Construction
Subscription-based services
Travel and hospitality
Manufacturing (custom orders)
How do advance payments affect the accounting of financial statements?
For the seller
Balance Sheet: Recognition as a liability, for example, as “Advance Payments” or “Deferred Revenue”.
Income Statement: Accounted for recognition only when the obligation is met.
For the buyer
Balance Sheet: Listed as an asset in the accounts, for example, “Prepaid Expenses”.
Income Statement: Being reported as an expense where the goods or services are received.
Advance Payments and Unearned Revenues – What is the difference?
Advance payments and unearned revenue refer to the same concept but from different perspectives:
Advance Payment: From the buyer’s point of view, it is an asset.
Unearned Revenue: From the seller’s point of view, it is an element of cost.
The courts have elaborated that, what happens if a seller of goods does not perform his contractual obligations?
If the seller fails to meet the obligation, he or she has mentioned then the advance amount paid by the buyer needs to be returned. Legal proceedings may follow suit in case of non-refund.