What is an advance payment?
– Definition: An advance payment is money paid before the related goods or services have been delivered. It’s a prepayment that shifts cash to the seller (or supplier) up front and creates a claim (an asset for the payer, a liability for the recipient) until performance occurs.
Why it matters (short)
– Protects sellers from nonpayment and helps them fund production.
– Gives buyers a way to secure scarce capacity or lock in price/terms.
– Affects accounting: the payer records a prepaid asset; the recipient records unearned revenue (a liability) until delivery.
Key terms (defined)
– Prepaid expense / prepaid asset: an amount paid in advance that will be recognized as an expense (or converted to inventory) when the related good/service is received.
– Unearned revenue (deferred revenue): money received by a seller for goods/services not yet provided; recognized as revenue when performance is completed.
– Advance payment guarantee: a bank or insurer-issued instrument that promises to refund the advance if the seller fails to perform.
How advance payments typically work
1. Buyer and seller agree on a contract that may require an up-front sum (percentage or fixed amount).
2. Buyer transfers funds to the seller before delivery.
3. Buyer records the cash outflow as a prepaid asset (accrual accounting).
4. Seller records the cash inflow as unearned revenue (liability).
5. When the goods/services are delivered, the buyer removes the prepaid asset and records the expense or inventory; the seller recognizes revenue and any cost of goods sold.
Common reasons sellers ask for advance payments
– Large/custom orders that require working capital for materials or setup.
– New or higher-risk customers (credit risk).
– To lock production capacity or guarantee firm pricing.
– Regulatory or programmatic reasons (e.g., some government advance payments or insurance-subsidy payments).
Important considerations for buyers and sellers (checklist)
For buyers:
– Confirm contract terms: amount, timing, refund/cancellation rules, applicable fees.
– Request an advance payment guarantee or bank guarantee if performance risk is material.
– Keep documentation: invoices, payment receipts, contract clauses about delivery/default.
– Note accounting treatment: record as a prepaid asset; reconcile when delivery/invoicing occurs.
– Consider currency, exchange-rate risk, and tax implications.
For sellers:
– Define allowable uses of the advance (materials, deposits) in the contract.
– Provide clear delivery milestones and conditions for returning advances if the order is canceled.
– Maintain separate bookkeeping for advances (liability account).
– Consider requiring guarantees or escrow for large sums.
– Comply with applicable tax and regulation requirements for received advances.
Worked numeric example (buyer and seller accounting)
Scenario: Company A orders custom equipment priced at $100,000. The supplier requires a 30% advance before manufacturing begins.
1) When Company A pays the advance (30% of $100,000 = $30,000):
– Buyer (Company A) entry (accrual basis):
– Debit Prepaid Advances (asset) $30,000
– Credit Cash $30,000
– Seller entry:
– Debit Cash $30,000
– Credit Unearned Revenue (liability) $30,000
2) When supplier ships the equipment and issues a $100,000 invoice:
– Buyer records receipt of the asset:
– Debit Inventory (or Equipment Expense) $100,000
– Credit Accounts Payable $70,000 (remaining amount owed)
– Credit Prepaid Advances $30,000 (to clear the advance)
(Net effect: buyer now shows the full $100,000 asset and a $70,000 payable.)
– Seller recognizes revenue and reduces the liability:
– Debit Unearned Revenue $30,000
– Debit Accounts Receivable $70,000 (if invoiced)
– Credit Sales Revenue $100,000
Notes on this example:
– Treatment depends on whether the buyer capitalizes the purchase (inventory / fixed asset) or expenses it immediately.
– Sales tax, shipping, customs, and cost-of-goods-sold entries are additional and omitted here for clarity.
Advance payment guarantees and protection
– An advance payment guarantee (issued by a bank or insurer) protects the buyer by pledging to refund the advance if the seller fails to deliver.
– Alternatives include escrow accounts, letters of credit, performance bonds, or staged payments tied to milestones.
– Choose the form of protection based on contract size, counterparty creditworthiness, and jurisdiction.
Typical real-world examples
– Prepaid mobile phone plans: customers pay before service is consumed.
– Rent paid at the start of a lease period: tenant pays before the rental period begins.
– Health-insurance Premium Tax Credit advances (U.S.): portion of a subsidy may be paid to insurers in advance for eligible taxpayers (program rules and reconciliation apply).
– Deposits for custom-manufactured goods or large equipment orders.
Risks and practical tips
– Risk of seller nonperformance; mitigate with guarantees, escrow, or staged payments.
– Buyer creditworthiness concerns: sellers may ask for advances from higher-risk buyers.
– Tax and reporting implications differ by jurisdiction; verify local rules.
– Keep clear contractual remedies and timelines for refunds or dispute resolution.
Quick checklist before agreeing to an advance payment
– Is the advance amount reasonable and proportional?
– Is there a written contract specifying delivery, refund terms, and remedies?
– Will you obtain a bank guarantee, escrow, or letter of credit for material sums?
– Is the accounting treatment understood and recorded correctly?
– Have you considered currency, tax, and regulatory implications?
– Are milestones and approvals defined for staged payments?
Reputable sources for further reading
– Investopedia — Advance Payment: https://www.investopedia.com/terms/a/advance-payment.asp
– Internal Revenue Service — The Premium Tax Credit (overview): https://www.irs.gov/affordable-care-act/individuals-and-families/the-premium-tax-credit
– Internal Revenue Service — Premium Tax Credit: Claiming the Credit and Reconciling Advance Credit Payments: https://www.irs.gov/affordable-care-act/individuals-and-families/premium-tax-credit-claiming-the-credit-and-reconciling-advance-credit-payments
– Cornell Law School, Legal Information Institute — Advance: https://www.law.cornell.edu/wex/advance
– U.S. Congress (text of H.R.1319, American Rescue Plan Act of 2021): https://www.congress.gov/bill/117th-congress/house-bill/1319
Educational disclaimer
This explainer is for educational purposes and does not constitute individual legal, tax, or investment advice. For decisions about large contracts, taxes, or guarantees, consult a qualified accountant, attorney, or financial professional.