Merchants and businesses of all stripe are often striving to grow but simultaneously looking to ensure that they can survive. As a result, as the cliché goes, cash is king! Most of the time, merchants transact in two forms; sell goods or services and receive cash payments on the spot or bill the customer for payment.
However, every so often, a business may get payments in advance. It may be the nature of the work being done where advance payments are required to get work started. Other times it may be the customer’s risk profile where business must be prudent and demand payments in advance. Regardless of the reasons for taking payments in advance, we look at some basic accounting rules of recording advance payments, why those rules may be important, and why businesses have to even be concerned with this.
Advance Payments – What are They?
Advance payments is a universal term for any amount of payment a business receives for goods and services before they are delivered or rendered. It can with different titles; Advance Payments, Customer Advances, or even Unearned Revenue. Some companies default to this mode of payment, while others use it with only specific clients or certain transactions to mitigate higher than usual risk.
Examples of where advance payments may be required are customers with no or poor credit, a batch of product is reserved for a certain client, or there is a one-off custom order from a client suitable only for them.
This depiction of cash being received but having to account for it based on specific accounting rules is referred to as the accruals-based accounting method. This method of accounting ignores when cash is being exchanged but instead focuses on when revenue is earned (delivery) and when expenses are incurred.
There are technicalities about advance payments that businesses need to be mindful of
There are some specific details as per accounting regulation that defines specifically what advance payments are. It revolves around the term “earned” which may be synonymous with the goods or services being “delivered”. Advance payments can be broken down into two scenarios listed below. It is important to understand that good need not be completely delivered in some cases. For example, if a contractor is building a house and it is only 25% complete, that is a quarter of the product delivered. What is delivered and what constitutes earned can be stipulated in the contract.
- Revenue is Earned if the goods or services have been delivered, either partially or completely, and payment is either received or will be billed for.
- Revenue is Unearned if the payment for goods or services has been received but has yet to be delivered, either partially or completely.
These are the accounting requirements that guide businesses on how to treat the money coming into the business.
Why do businesses even need to be concerned about accounting rules and advance payments?
There are important reasons why these accounting rules matter and the impact advance payments have on your business. Until the goods or services are delivered and although the business is recording revenue, any unearned revenue will have to be accounted for as a liability for the business. It is treated as debt on the merchant’s balance sheet. If revenue is earned, it is treated as income. Advance payments are great for liquidity and cash flows but there is still the debt element for the goods and services owed to the client.
Why is it important to appropriately account for advance payments?
One of the biggest reasons small businesses will even consider abide by the special rules for advance payments is that they may be stipulated by a financial institution to do so. Businesses often rely on credit from financial institutions, which will require them to furnish financial statements for a certain number of years. Those financial statements have to be prepared by an accountant based on the US Generally Accepted Accounting Principles (US GAAP), the basis of which is accruals-based accounting.
If a financial institution is looking to issue a credit to a business, they would seek to have an accurate understanding of how much debt a business already has. Advance payments are a great way to showcase locked-in streams revenue, and even more advantageous if advance payments are a normal course of business for your company.
Another reason is that be that if a company is large enough, i.e. has sales revenue of $5 million or more or holds an inventory of $1 million or more, it is legally required to use US GAAP to present financial statements and for tax preparation purposes.
Businesses have to continuously focus on optimizing their cash flow and constantly look to mitigate the various risks they encounter from the creditworthiness of some customers. All this while the look to the future for growth prospects and ensure there is ample liquidity and credit available. This may sometimes involve compliance with arcane accounting rules and what may seem like a convoluted way of recording simple cash transactions known as Advance Payments. Managing cash flow is critical to a business. However, it is equally vital to understand the requirements for billing your customers and how to recognize revenue for advanced payments.
Advance payments can be part and parcel for many industries, or specific to certain customers given their risk profile. Nonetheless, businesses need to understand the basics accounting rules of recording advance payments and their ramifications.