What is an advance payment?
Advance payment is a type of payment made before its normal due date, such as the payment of a good or service before receiving it.
Advances are sometimes required by sellers to protect against non-payment, or to cover the seller’s disbursements for the provision of the service or product.
There are many cases where advance payments are required. Consumers with bad credit may be required to pay companies in advance, and insurance companies generally require prepayment to extend coverage to the insured.
Key points to remember
- Advance payments are made before receiving goods or services.
- In many cases, advance payments protect the seller from non-payment in the event that the buyer fails to pay at the time of delivery.
- Companies record down payments on the asset side in their balance sheets.
- A prepaid cell phone is an example of prepayment.
Understanding advance payments
Advances are amounts paid before a good or service is actually received. The balance due, if any, is paid after delivery. These types of payments contrast with deferred payments or late payments. In these cases, the 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.
Advances are recorded on the assets side of a company’s balance sheet. As these assets are used, they are spent and recorded in the income statement for the period in which they are incurred.
Advances are generally paid in two situations. They are either applied to a sum of money supplied before a contractually agreed due date, or they can be demanded before receipt of the goods or services requested.
Examples of prepayments
There are many examples of advances in the real world. Take prepaid cell phones, for example. Service providers require payment for cellular services that will be used by the customer one month in advance. If the deposit is not received, the service will not be provided. The same goes for payments of rents or utilities to come before their contractual maturity.
Another example applies to eligible U.S. taxpayers who have received advance payments via the Premium Tax Credit (PTC) offered under the Affordable Care Act (ACA). Financial assistance due to the taxpayer is provided to the selected insurer before the actual credit maturity date.
Consumers with bad credit may also be required to pay advances to creditors before they can buy goods or services.
Governments also pay advances to taxpayers such as social security.
Special considerations: advance payments to suppliers
In the business world, companies often have to pay advances to suppliers when their orders are large enough to be binding on the producer. This is particularly true if the buyer decides to retract before delivery.
Advance payments can help producers who do not have enough capital to buy the materials needed to fulfill a large order, as they can use some of the money to pay for the product they will create. It can also be used as assurance that a certain amount of income will be generated by the production of the large order.
If a company has to make an advance payment, this is recognized as prepaid expense on the balance sheet using the accrual method.
Advance payment guarantees
A deposit guarantee serves as a form of insurance, guaranteeing the buyer that if the seller does not comply with the agreed obligation of goods or services, the amount of the deposit will be refunded to the buyer. This protection allows the buyer to consider a contract void if the seller fails, reaffirming the buyer’s rights to the initial funds paid.