Advance Payment: Definition, How It Works, and Key Considerations
Key takeaways
* An advance payment is money paid before goods or services are received.
* For the payer, advance payments are recorded as assets (prepaid expenses) and expensed when the good or service is delivered.
* Sellers benefit from reduced nonpayment risk; buyers can seek advance payment guarantees to limit that risk.
* Common examples include prepaid phone service, rent, utility prepayments, supplier deposits for large orders, and advance tax-credit payments for insurance.
What is an advance payment?
An advance payment is any amount paid ahead of receiving goods or services. It shifts payment risk away from sellers by ensuring they receive funds before fulfillment. Under accrual accounting, advance payments are recorded as prepaid assets on the balance sheet and become an expense on the income statement when the related good or service is delivered or consumed.
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How advance payments differ from deferred/arrears payments
- Advance payment: pay first, receive later.
- Deferred (arrears) payment: receive first, pay later (for example, salaried employees paid after work is performed).
Benefits and uses
- Protects sellers and suppliers from nonpayment.
- Provides working capital to producers who need funds for materials or production.
- Signals buyer commitment for large or custom orders.
- Can be required for buyers with poor credit histories.
Advance payment guarantees
An advance payment guarantee (or advance payment bond) functions like insurance: if the seller fails to perform, the buyer can invoke the guarantee to recover the advance. This mechanism reduces counterparty risk for buyers who must make upfront payments.
Supplier and corporate considerations
- Large or custom supplier orders commonly require deposits or advances to cover production costs.
- Corporations record required advances as prepaid expenses until the supplier delivers.
- Buyers should evaluate supplier creditworthiness, contract cancellation terms, and available guarantee mechanisms before making advances.
Examples
- Prepaid mobile service: customers pay in advance for a future month’s service.
- Rent and utilities: tenants sometimes prepay rent or utility deposits.
- Corporate deposits: manufacturers request partial payment for large, bespoke orders to fund materials and production.
- Advance tax-credit payments: some governments route advance payments (such as premium tax credits for health insurance) directly to insurers to reduce beneficiaries’ out-of-pocket costs.
Risks and protections
- Buyer risk: non-delivery or poor-quality delivery after payment. Mitigation includes advance payment guarantees, escrow arrangements, and clear contractual remedies.
- Seller risk: accepting reversals or chargebacks in certain payment methods. Sellers should set terms and verify buyer credit when possible.
Bottom line
Advance payments are a common commercial tool that balance risk and financing needs between buyers and sellers. They improve seller security and can finance production, but they expose buyers to delivery risk—contracts, guarantees, and prudent due diligence help manage that exposure.