Last Updated December 27, 2024
Advance payments in accounting are relatively common, but they can be confusing if you don’t understand how to process and record them properly as part of your accounts receivable process.
When utilized properly, advanced payments can improve your cash flow and mitigate risk while also helping your business improve its internal planning and budgeting practices. By understanding how to process and record advances from customers, as well as how to manage the client relationship side of these payments, you can make them work well for your business.
What Is an Advance Payment in Accounting?
In business accounting, the advance payment meaning refers to any payments that are made by the client before goods or services have actually been delivered by the service provider. Depending on the nature of the transaction, payments in advance may be required before the goods are shipped or before a service is completed.
Receiving advance payments can improve a business’s cash flow and accounts receivable turnover ratio, ensuring greater access to the funds needed to cover every day operating expenses or the expenses associated with a specific client order.
When Are Advance Payments Used in B2B Relationships?
In B2B relationships, advance payments could cover a portion of the agreed-upon cost for goods or services (more common), or the agreement might stipulate full payment in advance (less common).
For example, advance payments are often used for large projects that require major upfront costs on the part of the service provider. They are also frequently used for fulfilling a custom order when materials must be procured in advance or when the customized nature of the finished product means it could not be resold to a different customer.
Advance billing may be a business’s standard practice as a method of protecting against loss and covering the costs of providing its goods or services. In other instances, advance payments may only be required in select situations, such as when a new client has poor credit history and the service provider wants to mitigate their risk and ensure payment. In this case, payment advances from customers can help build trust between a supplier and its new client.
Many businesses also require that clients make an advance payment to secure services in the first place. Making an initial deposit secures the future order of a product or service.
Examples of B2B Advance Payments
The B2B world often sees advance payments in the form of down payments or deposits for select services. A service provider may require an initial deposit or down payment so it can gather necessary resources to complete the service. For example, a construction company might require an initial deposit so it can have the working capital to secure materials.
The deposit also guarantees the buyer’s commitment or can be used to reserve their spot, so to speak, particularly with a service provider that is in high demand. A consultant might require that clients pay a deposit to secure a spot for a paid consultation on their calendar.
How Do You Record Advance Payments in Accounting?
Understanding how to record advance payments in accounting is crucial to ensure that balance sheets, cash flow statements, and other financial records are maintained properly. Here is how to record these payments as part of your accounting process.
When the Buyer Makes an Advance Payment
For the buyer, an advance payment is recorded as a prepaid expense and is considered a current asset.
For the company that receives the advance payment, the transaction is recorded as a liability on the balance sheet under the heading “unearned income.” The cash account is debited, and the liability account is credited. The payment is considered a liability because the seller has not yet provided the agreed-upon product or service to the buyer. While the advance payment represents a positive contribution to the business’s cash flow and working capital, it is usually not considered revenue at this point.
When the Seller Delivers the Product or Service to the Buyer
Once the goods or services have been received by the buyer, the advance payment is no longer considered a current asset on the balance sheet. The payment is reclassified as an expense on the buyer’s income statement.
After the product or service has been delivered, the advance payment received by the seller is now considered “earned income.” The amount is transferred or debited from the “unearned income” liability portion of the balance sheet and is credited to accounts receivable. At this stage, the payment is considered to be part of the business’s revenue since the company has fulfilled its obligation to the buyer.
What Is an Advance Payment Guarantee?
An advance payment guarantee is an important element of any B2B agreement where the buyer is required to submit payment in advance. This is a written contract that offers protections to the buyer—essentially, to ensure that they get what they paid for.
An advance payment guarantee allows the buyer to recoup their advance payment from the seller if goods or services aren’t delivered as agreed upon through the contract arrangement. If the seller fails to deliver the agreed-upon products or services, the advance payments must be refunded.
Advance payment guarantees may also contain provisions for how to address disputes if products or services are delivered but fail to meet expectations. This could include stipulations for negotiating full or partial refunds, requiring the seller to redo the work, or other potential arrangements. In cases where the buyer is paying a deposit rather than making a full payment, these agreements will also set standards and requirements for submitting the rest of the payment upon completion of the work.
An advance payment guarantee is crucial for generating trust with B2B buyers, who might otherwise be hesitant to commit to any kind of advance billing. When sellers include an advance payment guarantee, it can help ensure that such payments are made in a timely manner by improving trust.
Other Considerations for Advance Payments
The following are other considerations you should keep in mind if you request advance payments from your clients prior to providing service.
Clearly Define Contract and Invoicing Terms
To avoid miscommunication with clients, your contract should clearly outline the full details regarding advance payments—how much of the payment is required in advance, what the delivery schedule for your product or service will look like after payment is received, any agreed-upon guarantees, dispute resolution, and so on.
Similarly, when you send an invoice with advance payment details, the invoice should clearly indicate how much of the total balance is currently due as an advance payment, as well as the remaining balance that will be due upon receipt of the finished products or services. As with a standard invoice, this should include payment terms, methods, and any other details that may be necessary.
Emphasize Transparency
Some clients may be hesitant to submit advance payments. You can alleviate concerns by clearly explaining why you require an advance payment, such as covering the cost of procuring essential materials and labor, mitigating the risk of non-payment with new clients, or something else entirely. Full transparency will build trust with clients and ensure timely receipt of their advance payment.
Be Mindful of Tax Implications
Remember, even if your company has not yet “earned” the revenue from an advance payment, these payments contribute to your working capital. You will likely be required to pay taxes on these payments.
Advance Payment vs. Prepayment
Advance payments and prepayments are very similar, which can result in some confusion—especially now that prepayments are more common than ever.
In the broadest sense, however, an advance payment is a payment that obligates the seller to deliver a product or service by an agreed-upon date in the future. A prepayment, on the other hand, gives the buyer rights for future consumption.
In B2B, the rise of SaaS tools has made prepayments a standard occurrence for practically every company. A monthly or annual premium is paid at the start of the billing period for a software tool—before the service has actually been used. Similarly, businesses pay premiums to their insurers at the start of a billing period to ensure coverage and financial protection later, if necessary. The client pays now, with benefits to be received in the near future.
Because of the nature of how prepaid products and services are delivered, prepayments are generally considered an asset rather than a liability.
In-Summary: B2B Advance Payments
Advance payments are a common practice, particularly in B2B transactions. Advance payments usually serve as a type of deposit before the supplier completes a service or delivers finished goods. Advance payments can help vendors manage their cash flow, particularly when fulfilling large orders, though the advance payment is considered a liability until the product or service has been delivered.
Advance payments require careful attention during the business accounting process, but they ultimately benefit sellers by improving their cash flow and reducing the risk of non-payment. By establishing clear contract terms that include an advance payment guarantee, buyers and sellers can both benefit from increased trust. Establishing clear guidelines for requiring and processing advance payments can become a significant benefit to your business.
Michael McCareins is the Content Marketing Associate at altLINE, where he is dedicated to creating and managing optimal content for readers. Following a brief career in media relations, Michael has discovered a passion for content marketing through developing unique, informative content to help audiences better understand ideas and topics such as invoice factoring and A/R financing.
