Advance payment

Definition

An advance payment, also known as a prepayment, is a financial transaction in which a payer provides funds to a payee before goods or services are delivered. This is typically done to secure a product or service in advance.

What is an advance payment?

The purpose is often to guarantee that a product or service will be provided by a specified date or to secure a spot in a queue for products or services in high demand.

In financial statements, an advance payment is typically recorded as a liability for the payee until the goods or services are delivered.

Overall, advance payments can be a mutually beneficial arrangement, as they provide assurance to both parties in a transaction. However, it’s important for both parties to clearly understand and agree upon the terms and conditions related to the advance payment.

Example of advance payment

1. Service contract and advanced payment:
   • On January 1st, XYZ Services enters into a service contract with ABC Corporation to provide consulting services throughout the year. The total agreed-upon fee for the services is $12,000, payable in advance.

   The accounting entry for the advanced payment is:

   $\text{Cash}(Asset)=\; \$12,000$

   $\text{Unearned revenue}(Liability)=\; \$12,000$

   This entry records the receipt of cash in advance from ABC Corporation and establishes a liability (Unearned Revenue) on XYZ Services’ balance sheet, indicating that the company has an obligation to provide services in the future.

2. Recognition of revenue:
   • Throughout the year, XYZ Services provides consulting services to ABC Corporation in accordance with the contract.

   As the services are delivered, XYZ Services recognises the revenue earned. For instance, if $1,000 worth of services is provided each month, the monthly accounting entry might be:

   $\text{Unearned revenue}(Liability)=\; -\$1,000$

   $\text{Service revenue}(Revenue)=\; \$1,000$

   This entry reflects the reduction of the unearned revenue liability and the recognition of service revenue as the services are performed.