As a merchant, making and receiving prepayments is a vital part of doing business – and comes with a huge array of benefits.
Receiving prepayments can give you better cash flow and more accurate forecasting, and offers cost-saving and convenience for your customers. While making prepayments helps you more accurately allocate resources – and enjoy your own time and cost-savings.
So, how can you use prepayments to make your business’s life easier? First, you’ll need to know exactly what prepayments are, how they work, and why they matter.
Below, we’re answering all these questions – and more. We’ll discuss how to record both incoming and outgoing prepayments in your business’s balance sheet, explain payment penalties, and unpack the difference between accrual basis and cash basis accounting. And, most importantly, explore why picking the right payment processor is crucial for helping you juggle your prepayments – and leverage faster, more accurate payments performance.
A prepayment is the act of making a payment for a product or service before it’s officially due – or before those goods, or that service, has been provided.
Essentially, a prepayment is one made ahead of the agreed-upon schedule.
Anyone – whether individuals, businesses, or any other type of organization – can make a prepayment. And they apply to various situations: such as loans, rent, subscriptions, or any other type of bill or expense. While a prepayment is similar to a deposit, deposits generally only cover a portion of the total owed amount. Prepayments cover the full cost.
In a typical sales process, orders are made by the buyer, then fulfilled by the seller.
Once the goods or services have been delivered, the seller sends an invoice, which – depending on the net payment terms involved – is paid within a set, pre-agreed timeframe.
Some payments, however – be it due to the nature of the service, or the relationship between the buyer and seller – need to be made upfront, before the goods are delivered. These ‘prepayments’ happen for a variety of reasons, and in a wide range of contexts. When your business receives a prepayment, for instance, it might be because:
From an accounting perspective, you’ll typically record a prepayment you’ve received as a current liability, and any prepayment you’ve made as a current asset. (We’ll explain more about how to record prepayments in your business’s balance sheet below.)
We’ve discussed the principle of prepayments – but how do they look in practice?
Some examples of prepayment include:
Sometimes, of course, the merchant isn’t the one making the prepayment – but receiving it. Here, a prepayment might look like:
Prepayments offer a huge array of benefits for all involved – including you, as the merchant (the seller or provider of the goods and services), and your customer (the buyer).
Let’s break those benefits down, first, for merchants. Prepayments provide:
How about the benefits for customers? Offering them the opportunity to prepay gives them:
How you record a prepayment in your business’s books will depend on whether you’re making the prepayment, or receiving it.
When you make a prepayment, it’s treated as an asset on your balance sheet until the goods or services you’ve bought are received in full.
Let’s say you, as a business, purchase a subscription for HR software with a Software-as-a-Service (SaaS) provider. It works out cheaper to pay for two years upfront, rather than on a monthly, recurring billing basis. So you make this prepayment (so called because you haven’t received the entirety of that two-year service yet) and record this in your business’s prepaid expenses account as an asset.
The total value of the two-year deal is $2,400 – so, $200 per month. Every month, then, you’d charge $200 of the total HR software subscription to the HR expenses account, to reflect each subsequent month’s usage of that total initial outlay. By the end of the two-year period, the prepaid asset is eliminated, and the $2,400 is reflected as an expense to the HR department.
When you receive a prepayment from your customer, it’s considered a liability – at least until you’ve delivered the purchased products or services to your customer in full.
Let’s say, for example, that you receive a prepayment of $2,000 for a product you’ll be delivering over the course of the next three months. This $2,000 enters your balance sheet as unearned revenue (so, a liability). Each of the following months, as you provide the service or deliver the goods, the liability decreases, and the revenue increases.
So, you’d debit $667 per each subsequent month from your unearned revenue total, while crediting it to your sales revenue total. After three months, that liability will be wiped, and your sales revenue will be $2,000 to the good.
Accrual and cash basis accounting are two different methods of recognizing and recording financial transactions – including prepayments.
So what’s the difference? Let’s explore.
Accrual basis accounting records transactions when they’re incurred – regardless of when the funds actually change hands.
This accounting method recognizes when the goods or services are received, or delivered – even if the payment took place earlier or later. The underlying logic or goal of accrual basis accounting is to match revenues with expenses in the periods they occur – thus providing a more accurate overall picture of a business’s financial health.
In accrual basis accounting, prepayments you make are initially recorded as assets, then – when the services or products are used, or consumed – gradually recognized as expenses.
Prepayments you receive are initially recorded as liabilities on your balance sheet as unearned revenue – before becoming recognized as revenue as your customer consumes the goods or services you’ve provided.
Accrual basis accounting is more complex than its cash counterpart, but provides a more granular, accurate representation of your business’s financial performance and position. As such, it’s required for larger companies, and is in line with Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS).
Cash basis accounting records transactions only when money actually changes hands.
This accounting method doesn’t take into account when the product or service is delivered, received, or used; it’s based solely on the timing of cash inflows and outflows.
In cash basis accounting, prepayments you make are immediately recorded as expenses on your income statement – regardless of when the services or products are consumed.
Prepayments you receive are recorded, straight away, as revenue – irrespective of when you dispatch or deliver the goods or services to your customer.
Cash basis accounting is more simple than the accrual variety, but – because of the potential mismatch between cash flow and economic activity – generally doesn’t provide as accurate a depiction of your business’s financial health.
While prepayments offer a rich set of benefits, there’s one potential drawback to making them – and that’s a prepayment penalty.
A prepayment penalty is a charge a creditor or lender imposes when a borrower pays off a loan or debt before its agreed-upon maturity date. Prepayment penalties are most commonly associated with installment-based loans: such as car loans, personal loans, and mortgages.
Let’s take mortgages as an example.
When the bank pays out the home loan, it’s banking on a certain return threshold, which it calculates based on the size of the mortgage, the interest rate, and the duration of the loan. If you pay up your home loan earlier than expected, the bank misses out on a potentially significant chunk of the income it expected – so it passes down a penalty to compensate.
A prepayment penalty might be:
Accepting and receiving prepayments has a wealth of benefits: from forecasting your business’s cash flow to future-proofing your brand and bottom line through more engaged, loyal customers.
That all requires efficient accounting and a focused, fastidious approach to balancing your business’s books. And all that requires intuitive, unencumbered access to all your business’s latest payment data. Without it, you’ll struggle to know who’s paid, who’s prepaid, who hasn’t paid. With it, you’ll have all these figures at your fingertips – ready to integrate seamlessly with your accounting and reconciliation efforts.
How can you get this data? Partnering with a reliable payment service provider like Checkout.com is an excellent place to start.
Our payment processing solution helps you track, analyze, and optimize every payment you take – allowing you to monitor insights, then draw upon them to adapt your business’s offerings to the ever-evolving expectations of your audience.
We’ll help you harness techniques like straight through processing (STP) to automate error-strewn manual prepayment processing – and enjoy faster, more seamless payments. And, through automated payment reconciliation, take the dread and drudgery out of one of accountancy’s most tiresome tasks.
Ready to boost your business’s prepayment and reconciliation processes – and discover an end-to-end payments solution that actually works for you? Get in touch with the team here at Checkout.com today for a no-obligation chat. Your accountant will thank you!