What is Advance Payment?
An advance payment, or simply an advance, is the part of a contractually due sum that is paid or received in advance for goods or services, while the balance included in the invoice will only follow the delivery. Advance payments are recorded as a prepaid expense in accrual accounting for the entity issuing the advance.
Advanced payments are recorded as assets on the balance sheet. As these assets are used they are expended and recorded on the income statement for the period in which they are incurred. Insurance is a common prepaid asset, which will only be a prepaid asset because it is a proactive measure to protect business from unforeseen events.
introduction of Advance Payments
Advance payments are amounts paid before a good or service is actually received. The balance that is owed, if any, is paid once delivery is made. These types of payments are in contrast to deferred payments—or payments in arrears. In these cases, goods or services are delivered first, then paid for later. For example, an employee who is paid at the end of each month for that month’s work would be receiving a deferred payment.
Advance payments are recorded as assets on a company’s balance sheet. As these assets are used, they are expended and recorded on the income statement for the period in which they are incurred.
Advance payments are generally made in two situations. They can be applied to a sum of money provided before a contractually agreed-upon due date, or they may be required before the receipt of the requested goods or services.
How to Account for Advance Payment?
A buyer making an advance to the seller shall record the transaction by debiting the seller’s account and crediting the cash or bank account. We show the debit balance of the seller account as a current asset in the books of accounts of the buyer until the goods or services are received and the invoice issued.
To account for an advance, the seller needs to debit cash or bank account and credit the buyer account with the same amount. The credit balance of the buyer account increases current liabilities.
Once the customer receives the required goods or services, the seller or institution has to send an invoice to the customer. The invoice contains the total amount owed after subtracting it. Once completing all this procedure, the institution or seller has to record the following transactions in the books of accounts:
- Revenue is credited
- Accounts receivable are debited
- The customer or buyer account is debited.
Importance of Advance Payments
Advance payments are sums charged before the goods or services are finally received. The balance due, if any, shall be paid as soon as the payment is made. These forms of payments are in contrast to deferred payments or arrears payments. In these instances, goods or services are delivered first and then paid for later. For example, an employee who is compensated for that month’s work at the end of each month.
Advance payments are reported as assets on the balance sheet of the company. When these assets are used, they are spent and reported on the income statement for the period in which they are incurred.
Advance payments are typically made in two cases. They may refer to the sum of money paid before the contractually negotiated due date, or they may be needed before the goods or services demanded are obtained.
Advanced Payments in Big Businesses
Companies that manufacture large, expensive pieces of machinery – such as fighter planes or commercial airliners – often require advance payments as part of the payment structure for delivery. There are many reasons that it is in their best interest to do so.
The first primarily being that it shows a commitment from the buyer that they are invested in the delivery of the product. It is a significant gesture, especially if the payment is non-refundable and substantial.
The second reason is that it provides capital to fund costly projects. In the aircraft example above, it can provide the necessary capital needed to construct something that may end up costing hundreds of millions of dollars. It will help aircraft manufacturers to avoid going to a bank or financial institution for money.
Criticisms exist of some large businesses that employ such a type of payment method. When companies ask for advance payments from ordinary consumers, it can be like a company requesting an interest-free loan en masse. However, it is also an effective way of promoting product scarcity, and it is an effective marketing tool.
Advanced Payments in a Startup
One of the critical components of getting a start-up off the ground is capital raising and funding. Often, entrepreneurs lack the existing capital required to fund and grow their business themselves. Online platforms, such as Kickstarter, are one way for budding entrepreneurs to get access to funding to build their product and take it to market.
With such a type of capital raising, interested contributors make advanced payments for products they wish to see the company produce. They do it to get contributor bonuses or to be among the first to receive the product. Such types of advanced payments are completed as a unique way of bringing products to market that may otherwise never get launched.
Advance Payment Guarantee
Prepayments protect the sellers from unforeseen losses, but it is a bad deal for buyers as it poses a risk for them. If the seller cannot deliver the goods on time, buyers could be in a difficult position. For this purpose, an advance payment guarantee serves buyers as insurance by protecting them from such a situation.
According to this, if a seller somehow can’t deliver the goods on time, the institution or the seller has to refund all the prepayment to buyers. Therefore, buyers can consider the deal void if the seller cannot deliver.
Importance of Advance Payment
Protection to the Seller: Advance payment protects the seller from the buyer with a bad credit score and nonpayment.
Provides Financial Assistance: Provides financial assistance to the seller in making the goods.
Trust Builds Up: Trust is the most critical and difficult thing in the business to earn, and when a buyer makes a prepayment even for the nonrefundable deals, the trust between the buyer and the seller grows.
Guarantee to the Buyer: The guarantee assures the buyer that if the seller is unable to stay on its words, the seller will refund the prepayments into the customer’s account.
Risks with Advance Payment
One of the most significant risks with the advance payment is for customers. They may get into trouble if the seller fails to fulfill the deal. In addition, it might be challenging for buyers to get their money back once the company they invested in is declared bankrupt. Most buyers prefer to make payments only when they get what they want.
Risks with Advanced Payments: Getting Your Money Back
One potential disadvantage that exists when utilizing the advanced payment method as a consumer is that you may encounter difficulties in reclaiming your capital should the company you’re investing in go bankrupt. Without a strong contract in place that can protect your payment, you may find yourself in a drawn-out legal battle to reclaim your payment.
The above highlights the critical reason for fully understanding the nature of an advanced payment that you are contributing towards. In doing so, you will understand the opportunity costs of doing it.
Platforms like Kickstarter often employ a threshold barrier that capital raisers must obtain to be allowed to collect the money they’ve raised. It can provide peace of mind and an effective way for contributors to get their money back if other consumers do not share their optimism for a product or service, and it becomes no longer financially viable.
Special Considerations: Advance Payments to Suppliers
In the corporate world, companies often have to make advance payments to suppliers when their orders are large enough to be burdensome to the producer. This is especially true if the buyer decides to back out of the deal before delivery.
Advance payments can assist producers who do not have enough capital to buy the materials to fulfill a large order, as they can use part of the money to pay for the product they will be creating. It can also be used as an assurance that a certain amount of revenue will be brought in by producing the large order.
If a corporation is required to make an advance payment, it is recorded as a prepaid expense on the balance sheet under the accrual accounting method.’
Examples of Advance Payments
There are many examples of advance payments in the real world. Take prepaid cell phones, for example. Service providers require payment for cell services that will be used by the customer one month in advance. If the advance payment is not received, the service will not be provided. The same applies to payments for upcoming rent or utilities before they are contractually due.
Another example applies to eligible U.S. taxpayers who received advance payments through the Premium Tax Credit (PTC) offered as part of the Affordable Care Act (ACA). The financial assistance helps citizens, that meet household income requirements, pay for their health insurance. The money due to the taxpayer is paid to the insurance company in advance of the actual due date for the credit.
Consumers with bad credit may also be required to provide creditors with advance payments before they can purchase goods or services.