Advance Payment

Advance Payment Meaning

Advance Payment is a payment that is made by a buyer to the seller before the actual scheduled time of receiving the goods and services. It protects the seller from the risk of non-payment that could happen in the future. Additionally, it can help the seller financially in the production or procurement of the goods or rendering of services. It appears on the assets side of the balance sheet as a prepaid expense for the buyer. Such advances are usually required when a buyer had defaulted payments in the past, so it protects the sellers from such unforeseen events.

How to Account for Advance Payment?

For Buyer: A buyer making an advance to the seller shall record the transaction by debiting the seller account and crediting the cash or bank account. We show the debit balance of the seller account as a current assetCurrent AssetCurrent assets refer to those short-term assets which can be efficiently utilized for business operations, sold for immediate cash or liquidated within a year. It comprises inventory, cash, cash equivalents, marketable securities, accounts receivable, etc.read more in the books of accounts of the buyer until the goods or services are received, and the invoice issued.

For Seller: To account for an advance, the seller needs to debitDebitDebit is an entry in the books of accounts, which either increases the assets or decreases the liabilities. According to the double-entry system, the total debits should always be equal to the total credits.read more cash or bank account and credit the buyer account with the same amount. The credit balance of the buyer account increases current liabilitiesCurrent LiabilitiesCurrent Liabilities are the payables which are likely to settled within twelve months of reporting. They're usually salaries payable, expense payable, short term loans etc.read more. 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 is debited
  • The customer or buyer account is debited.
Advance Payment

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For eg:
Source: Advance Payment (wallstreetmojo.com)

Examples

‘Prepaid cellphones’ is an example of an advance payment. The customer has to make payment for the prepaid cellphone in advance to enjoy the benefit of it for a month. The service provider provides service for one month only when it receives the prepayments. Likewise, ‘Prepaid rent’ or ‘utilities’ are other such examples.

The other important example is the U.S ‘taxpayers’ receiving advance payments from the premium tax credit (PTC). It helps the citizens in household activities and for other purposes. The due money of the taxpayer is paid to the insurance company in advance.

Advance Payment in Businesses

Companies that are involved in the manufacturing process need payment in advance as it will show commitment from the buyer’s side that they are willing to purchase and will buy it in the future. It protects the business from unforeseen losses. It also shows the trust of the buyer for the seller as many of these advance payments are nonrefundable.

It provides capital to the seller for the construction of the required goods or services. And it saves the seller from using their wealth or taking a loan for the making of the product.

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 is unable to 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, then the institution or the seller has to refund all the prepayment to buyers. Buyers can consider the deal as void if the seller is unable to deliver.

Importance

  • 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 non-refundable 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, then the seller will refund the prepayments into the account of the customer.

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 fulfil the deal. It might be challenging for buyers to get their money back once the company they had invested in is declared to be bankrupt. That’s the main reason most of the buyers prefer to make payment only when they get what they wanted.

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