How to use advance payments to reduce risk

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 payments.

What is an advance payment?

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.

What circumstances warrant a payment in advance?

There are a number of reasons why you should require an advance payment from certain clients. The circumstances of each business are often vastly different, and depending on the type of project you are undertaking or order you are expected to fulfil, an advance payment can be a necessary insurance policy to protect your business’ profit margins.

Reasons for charging advance payments include:

• 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.

In these circumstances, an advance payment can protect you from financially damaging situations.

How do advance payments work?

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.

Be aware of your project estimates

You should only agree to an advance payment once you have a projection for your project’s estimated final costs. This projection should be as accurate as possible in order to create an advance payment invoice, as you could run the risk of charging a client too much or too little if all project costs have not been considered.

Advanced payments can be a great way of covering the expenses involved with completing a project, without having to dip into your own profit margin.

How do I write an invoice for an advance payment?

Although advance invoices can differ between businesses, a typical advance invoice should contain all of the following:

• Your business name and address

• The client’s business name and address

• A unique invoice number

• VAT details (if VAT registered)

• Date the invoice was issued

• Detailed breakdown of goods and services paid for

• Payment terms and timeframe

Pros and cons of advance payments

While getting your money upfront might seem like it can only benefit your business, there are both pros and cons of advance payments.

Pros:

• The project will be financed upfront, reducing your risk of losing money

• Revenue and expenses from the project are accounted for in the same period

• The need to pursue collections is rare

• Maintaining a consistent cash flow is easier

• The process of setting up automated invoices is simplified

Cons:

• 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.

Advance billing vs. billing in arrears

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 invoice 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.

How to account for advance payments

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 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.

How to accept advance payments: Best practices for advance billing

If you are going to accept prepayment, here are a few guidelines to follow:

1. Consider whether advance payment is the best course of action for certain clients/projects.

2. Use online invoicing software to manage invoices—with QuickBooks Online, you can create, send, and track invoices.

3. Pay attention when doing your accounting to ensure that you are correctly budgeting advance payments.

4. Shift advance payments to revenue instead of using a reversing entry to account for these transactions.

Advance payment guarantees

Your buyer may request that an advance payment guarantee is provided before sending a payment to your business. This type of agreement provides insurance to the buyer that they will receive a refund of their advance payment should your business fail to deliver the agreed goods or services, or if any other agreed upon conditions are not met.

Offering an advance payment guarantee can be a good way to establish trust between your companies, particularly if the client is unsure about making an advance payment.

Advance payment invoice template

Your advance invoice template should be as detailed as possible, providing a breakdown of all advance costs, the items or services a client is receiving, expected payment dates, and contact information of any relevant employees. 

VAT SUMMARY

*This template for advance payment is provided by QuickBooks as guidance. Always make sure your payments team, accounting team, or any other relevant parties review your invoices before sending them to a client.

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