One of the biggest risks businesses take is providing goods and services without payment. While this is the way things are often done in business, that doesn’t mean there isn’t another option. Instead, you could choose to require advance payments for your goods and services, or just for certain projects.
Advance payments are a way to reduce your risk and ensure you have the working capital you need upfront. However, if you are going to accept advance payments, you’ll need to account for these deposits or full payments correctly.
If you’re interested in trying this billing method, but don’t know where to start, we have you covered. In this guide, we’ll cover what advance billing is, the benefits of this billing method, and how to process advance payment.
- What is an advance payment?
- How do advance payments work?
- Pros and cons of advance payments
- Advance billing vs. billing in arrears
- How to account for advance payments
- How to accept advance payments: Best practices for advance billing
An advance payment is a type of payment that is made before a service has been rendered. With advance billing, invoices are sent to clients before the project has been completed. Advance payments can be a deposit, partial payment, or full lump sum. For example, progress payments—partial payment for work that’s been completed so far—can be a type of advance payment.
There may be several reasons for charging advance payment:
- To cover the cost of materials required for a project with large out-of-pocket expenses
- To act as insurance for especially larger orders
- To reduce a company’s risk of nonpayment
- To allow customers to reserve goods on preorder
- The customer requests to pay upfront—may be the case if they use cash-basis accounting or want a transaction included for this tax year
Facing the financial uncertainty that the coronavirus pandemic has placed on many businesses this past year, more businesses may consider advance billing. It’s an easy way to get money in your hands faster, so you can meet current financial demands until COVID-19 restrictions are removed. Examples include selling gift cards that can be redeemed once your business reopens or selling tickets that will be redeemed later for future events.
To collect advance payment, your business will need to estimate the budget for the goods or services being purchased. It’s important to be as accurate as possible because it will reduce the risk of overcharging and having to issue a refund or reimbursement. This is especially important when scoping out a project.
Once you send the invoice and receive payment from the client, you’ll need to record the transaction.
We’ll cover more about how to account for and process payments later.
While getting your money upfront might seem like it can only benefit your business, there are both pros and cons of advance payments.
- Customers may not be comfortable paying in advance—especially if they’ve never worked with you before
- Changes to a project’s scope will need to be applied to the next invoice
- Issuing refunds is more complicated
So, what is the alternative if the cons have instilled doubt that advance billing is right for your business? Billing in arrears—also known as deferred payment—might be better suited to your business operations.
There are two general options for billing clients: advance billing and billing in arrears. Advance billing is when you invoice a customer before the service or work is complete. Billing in arrears is when you bill a customer after the work is complete.
Depending on your business and preferences, one billing method may be better suited for you over the other. Each billing method has its own advantages and disadvantages. Let’s take a closer look at the differences between advance billing and billing in arrears:
- By billing in advance, you have startup capital to use toward the project. However, some customers are not comfortable paying upfront when they haven’t seen the finished product.
- With billing in arrears, you can prove the quality of your work before requiring payment. In this way, billing in arrears is an easier way to build trust with your clients. However, you also have to put trust in clients to pay their bill.
- With advance billing, you don’t have to worry about following up for payment. However, if additional work or materials are needed, you’ll have to charge the customer on a separate invoice, meaning you won’t get paid until later.
- With billing in the arrears, you run the risk of having to continuously follow up with clients for payment. In some cases, these unpaid invoices may fall through the cracks. However, you can include the total for everything involved with the project on a single invoice, even if changes occur.
- With advance billing, you run a higher risk of having to issue a refund. This can be the case when a client cancels a job before it’s completed or when it’s completed for less than the original quote.
- With billing in arrears, refunds are much rarer because you don’t receive payment until completion.
When deciding which billing method is best, consider these differences and the type of services you’re providing. Typically, advance billing is better suited for recurring clients with repetitive projects, while billing in arrears is better for one-off projects that may change. You may even choose to start with billing in arrears for the first payment, then switch over to advance payment for future projects. This may be a valuable part of client relationship building.
Depending on whether you are making or receiving advance payment, the accounting process is different. We’ll cover both instances below.
When you receive an advance payment from a client
When you receive an advance payment from a client, you will record it as a liability. To do this, you will need to debit the cash account and credit the liability account. Then, once the job is complete or goods are delivered, you will complete revenue recognition. This is done by debiting the liability account and crediting the revenue account.
Unearned income is recorded on the balance sheet. Once goods or services are rendered, this amount can be transferred to the income statement as earned revenue.
When using QuickBooks Online for an advance payment from a client, here are the steps you should follow:
Step 1: Credit the liability account
- Add a new entry to Chart of Accounts
- Select New, Account Type, then Current Liabilities from the drop-down menu
- Select Trust Accounts – Liabilities from the drop-down menu
- Name the account
Step 2: Debit the cash account
- Add a new entry to Products and Services
- Select New, then Service from the Product/Service information panel
- Name the product or service being provided
- Select Trust Liability Account from the Income account drop-down menu
Step 3: Create an invoice for the advance payment—you can also create a cash memo instead
- Select Invoice
- Select the client’s name from the drop-down list
- Select the product/service item you just set up in the Product/Service column
- Enter the payment amount received in the Rate or Amount column
Step 4: Transfer advance payments to income
- Create new transfer by selecting New, then Transfer
- Select the trust liability account you created in Step 2 from the Transfer Funds From drop-down menu
- Select the operating bank account from the Transfer Funds To drop-down menu
- Enter the amount of the advance payment that is now revenue
Income is not recognized until you have delivered the goods or completed the services.
When you make an advance payment to a supplier
Advance payments made to suppliers are recorded as a prepaid expense on the balance sheet—as long as your business uses the accrual accounting method.
When using QuickBooks Online to account for advance payment you’ve made to a supplier, you’ll use the Expense feature and follow these steps:
- Add the supplier to QuickBooks if you haven’t already. To add a supplier, go to Expenses, then select Suppliers and fill out the business’s information.
- Once you’ve added the supplier to QuickBooks, add a new expense. Select a Payee and Payment Account.
- Under the Category column, select Account: Accounts Payable (A/P).
- Input the payment description and amount.
- Save the payment before you close out.
If you are going to accept prepayment, here are a few guidelines to follow:
- Consider whether advance payment is the best course of action for certain clients/projects.
- Use online invoicing software to manage invoices—with QuickBooks Online, you can create, send, and track invoices.
- Allow for online invoice payments. With QuickBooks Payments, once a pay-enabled online invoice is paid, it can be automatically added to your books.
- Pay attention when doing your accounting to ensure that you are correctly attributing revenue from advance payments.
- Shift advance payments to revenue instead of using a reversing entry to account for these transactions.
Don’t get overwhelmed by advance payments; using QuickBooks accounting software can simplify the process of accepting advance payments and ensuring they’re recorded correctly.
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