Recording prepayments can be confusing for many small business owners.
Fortunately, Xero provides flexible tools to accurately track advanced payments, ensuring you recognize revenue appropriately while fulfilling obligations to customers.
In this guide, you'll discover step-by-step instructions for recording prepayments in Xero, whether entering them manually or utilizing automation, along with recommendations for avoiding common accounting mistakes.
Introduction to Prepayments and Advanced Payments in Xero
Prepayments, also known as advanced payments, refer to money received from a customer before a product or service has been delivered. Tracking prepayments is an important accounting task for small businesses using Xero software.
Defining Prepayments and Their Role in Accounting
A prepayment represents an obligation on the business to provide goods or services in the future. It allows customers to pay upfront for products or services they have ordered but not yet received.
For the business, prepayments provide cash flow and visibility into upcoming work. However, it is crucial to track prepayments accurately to avoid counting the money before fulfilling obligations or delivering the products/services.
The Importance of Accurate Prepayments Recording
There are several key reasons why properly recording prepayments matters:
- Prevents double-counting revenue before obligations are complete
- Ensures customer obligations are fulfilled
- Provides visibility into work pipelines and upcoming delivery dates
- Enables accurate financial statements and reporting
Careful prepayments tracking prevents overstated revenue and ensures transparency into upcoming work and cash flow.
Benefits of Using Xero for Prepayments
Xero provides automated accounting tools to simplify prepayments tracking including:
- Prepayments tracker linking advanced payments to invoices
- Automatic calculation of unearned revenue
- Repeating journals to record deferred income
- Detailed reporting on prepayments status
With streamlined recording of prepayments in Xero, small businesses can achieve more accurate revenue recognition, financial statements, and fulfillment of customer obligations.
How do I enter a prepayment in Xero?
On the Create tab, select "Add Details" to access the dropdown menu. Choose "Prepayment" and fill in the relevant details:
- Select the appropriate prepayment account
- Enter the prepayment amount
- Select the correct tax rate if applicable
- Add any additional details as needed
Once complete, save the prepayment entry. This will create a trackable prepayment asset on the balance sheet.
When you receive the invoice for services rendered or goods delivered against the prepayment, you can apply the prepayment amount to that invoice. This will automatically reconcile the prepayment tracker.
Using prepayment accounts and entries in Xero provides transparency into advanced payments and ensures proper tracking as services or products are fulfilled over time. Key benefits include:
- Prevents prepayments from artificially inflating expenses
- Enables accurate financial reporting
- Simplifies invoice reconciliation when goods/services are received
- Reduces accounting errors related to advanced payments
With a few clicks, prepayments can be seamlessly handled in Xero without needing manual journals or repeating entries. This saves significant time while enforcing best practices around accounting for advanced payments.
How do I reconcile an advance payment in Xero?
RECONCILING AN ADVANCED PAYMENT
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Set up a current liability account for this advance payment and make sure the "Enable payments to this account" option is selected. This will allow you to track the advance payment separately until it is reconciled.
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Record the advance payment as a "Spend Money" transaction coded to the new liability account. This registers the inflow of cash and creates a balance in the liability account.
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When you deliver the product or service relating to the advance payment, create an invoice in Xero as usual.
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Allocate part or all of the advance payment to this new invoice. This will reduce the balance in the liability account as the advance is reconciled.
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Repeat steps 3-4 as you continue delivering products/services to the customer. The advance payment liability will decrease with each allocation until fully reconciled.
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Any remaining balance in the advance payment liability account represents services yet to be delivered in the future.
Reconciling advance payments in this way provides transparency in Xero, allowing you to accurately track the status of any customer prepayments. It ensures the cash is registered properly while also matching it against actual invoices over time. This prevents advance payments from getting "lost".
With a few simple account adjustments, advance payments can be seamlessly managed in Xero without manual calculation or tracking outside the system.
How do you record prepayments?
Recording prepayments in accounting can seem complicated, but following these key steps will ensure you account for them properly in Xero:
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Make the upfront payment. When you pay for something in advance - like paying 3 months of rent upfront - record the transaction in Xero as you normally would through the bank feed, imported bank statement, or manual journal entry.
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Enter a prepayment journal. Create a manual repeat journal in Xero crediting your Prepayments account and debiting your Bank account for the full amount paid. This tracks the prepayment as an asset on your balance sheet.
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Allocate the prepayment over time. As you receive the prepaid goods or services, create manual journals to debit the relevant Expense account and credit the Prepayments account. This allocates a portion of the upfront payment to each period's income statement.
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Set up repeating journals. To easily expense a portion of the prepayment each month, set up a repeating manual journal to debit the prorated amount to Expense and credit Prepayments automatically.
Following these 4 key steps ensures you accurately record the entire upfront prepayment transaction from initial payment to final allocation over time. Reach out to your accountant if you need help setting up the necessary accounts and journals in Xero.
What is the difference between prepayment and overpayment?
Overpayments and prepayments are handled differently in Xero.
Overpayments
Overpayments sit as credits on existing sales invoices or bills. They can be:
- Refunded to the customer or supplier
- Allocated against future invoices or bills for the same contact
For example, if a customer pays $120 but their invoice is only $100, there will be a $20 overpayment credit on that invoice. You can refund the extra $20, or apply it to their next invoice.
Prepayments
Prepayments are payments received before an invoice is issued or goods/services delivered. Unlike overpayments, prepayments:
- Are not linked to existing invoices or bills
- Sit in balance sheet accounts like Prepayments Received or Prepayments Made
- Are tracked with separate prepayment journals
When you receive a prepayment, you record it in a prepayment journal. Later, when you deliver the goods/services, you apply the prepayment to the invoice to reduce the amount owed.
The key difference is overpayments apply to existing invoices, while prepayments are payments for future invoices. Prepayments sit on the balance sheet until allocated, while overpayments create a credit on existing invoices/bills.
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Understanding Prepayments in Xero Accounting Software
This section delves into the specifics of handling prepayments within Xero, detailing the accounting principles involved and the features Xero provides to manage them effectively.
Accounting for Prepayments: The Basics
When a business receives payment from a customer before delivering goods or services, this is considered a prepayment. Proper accounting of prepayments involves:
- Recording the prepayment amount as a credit to the Cash/Bank account when received. This increases assets.
- Recording a matching debit to a liability account such as Unearned Revenue or Customer Deposits. This represents the obligation to deliver the goods/services in the future.
Later, when the product or service is delivered to the customer, the prepayment liability is reduced by:
- Raising an invoice for the full amount which credits Unearned Revenue.
- Recording the invoice payment (already received) by debiting Cash/Bank.
This process adheres to the matching and revenue recognition principles in accrual accounting. It ensures revenue is only recorded after delivery, while also tracking prepayments separately until they are earned.
Automating Prepayments with Xero's Prepayments Tracker
Manually recording prepayments as above can be tedious for high transaction volumes. Xero provides an automated Prepayments Tracker feature for simplified management:
- When a prepayment is received, it is logged in the Tracker rather than through manual journal entries.
- The Tracker links the payment to specific products/services and expected delivery dates.
- On the delivery date, Xero automatically triggers an invoice matched to the prepayment. This recognizes the revenue.
- The Tracker provides an overview of expected future invoices from prepayments received.
This streamlines accounting for prepayments in Xero, especially useful for small businesses with many advanced payments.
Comparing Manual Journal and Prepayments Tracker
The core accounting treatment for prepayments is consistent between manual journal entries and using Xero's Prepayments Tracker. However, the Tracker provides significant process efficiencies:
- Automated matching of prepayments received to invoices raised later. The manual method risks errors in matching.
- Clear visibility into upcoming invoice commitments from existing prepayments. Manual prepayment liability accounts provide no visibility.
- Reduced data entry as payment details are logged once on receipt. Manual journals require double entry both on receipt and invoice.
On the other hand, manual journals provide more flexibility for complex prepayment scenarios that don't fit Xero's predetermined workflow.
Overall, Xero's Prepayment Tracker dramatically simplifies prepayment management for many small businesses. But manual journals still have a place when specialized accounting treatment is required.
Recording Prepayments: A Step-by-Step Guide
This section provides a comprehensive walkthrough on how to record prepayments in Xero, offering practical steps and tips to ensure accuracy and compliance.
Creating a Manual Journal Entry for Prepayments
When you receive a prepayment from a customer for products or services to be delivered at a future date, you need to record this transaction properly in Xero. Here are the key steps:
- Go to Accounts > Journals > New Manual Journal
- Select the bank account where you received the prepayment funds
- Credit the prepayment account (liability account) with the amount received
- Add the customer name and other details in the journal description
- Save the manual journal entry
This records the prepayment funds as a liability until you fulfill the order. The key is linking the prepayment to the specific customer and tracking it over time.
Utilizing the Prepayments Tracker for Advanced Payments
Xero's Prepayments Tracker enables you to allocate prepayments received to specific products, quantities, and future dates when you will fulfill the obligation. To use it:
- Go to Accounts > Prepayments > Track Prepayments
- Click New Prepayment and enter the customer details
- Specify the items, quantities, unit prices and delivery dates
- Xero links the prepayment tracker to your accounts
This greatly simplifies tracking when you receive cash upfront and need to fulfill orders later.
Issuing Invoices Against Prepayments
On the specified fulfillment date for any prepayments tracked:
- Go to Accounts > Prepayments
- Locate the open prepayment and click Create Invoice
- Review the invoice details matched to the original prepayment
- Click Approve to issue the invoice
This automatically clears the prepaid funds and satisfies your delivery obligation to the customer per the terms.
Monitoring Prepayments with Xero Reports
Key reports for visibility into prepayments include:
- Prepayments Reconciliation - Summary of all prepayments, open balances, and money still owed
- Aged Receivables - Shows prepayments as negative amounts until future invoices issued
- Balance Sheet - Prepayments appear as liabilities until fulfilled
Running these reports periodically lets you track upcoming deadlines for open prepayment obligations.
Accounting for Different Types of Advanced Payments
Handling prepayments in accounting can be nuanced depending on the type of upfront payment received. As a small business using Xero, it's important to understand best practices for recording various advanced payments to ensure accuracy.
Handling Deposits for Custom Orders in Xero
When a customer pays a deposit for a custom order to be fulfilled at a future date, it's essential to link the deposit to the obligation it represents. Here are some tips:
- Create a separate bank account in Xero called "Customer Deposits" to track deposits separately.
- Record the deposit payment in this account via manual journal entry or bank feed.
- In the reference field, note the customer name and order details.
- When you fulfill the order later, apply the deposit payment to the final invoice.
- This connects the cash received to the future obligation, maintaining accuracy in Xero.
Managing Subscriptions and Retainers as Prepayments
For ongoing services billed in fixed cycles, like subscriptions or retainers, prepayments require special handling:
- Enable the "Repeating Invoices" feature in Xero to automatically bill subscribers.
- Record any prepayments to "Unearned Revenue" via manual journal entry.
- When you run the repeating invoices over time, the unearned revenue will reduce accordingly.
- This ensures revenue recognition matches delivery of services over long periods.
Recording Prepaid Packages and Gift Cards
For prepaid service packages or gift cards, use Xero's Prepayments feature:
- Enable "Prepayments" and create prepayment accounts for each offering.
- Record package payments to the associated prepayment account.
- When customers use services, reduce the prepayment balance via manual journal entry.
- Run reports on prepaid balances to track usage over time.
Tracking Down Payments on Large Projects
For large projects with multiple phases, track deposits against work completed:
- Note the project and expected phases in the bank feed when you receive the deposit payment.
- As you complete and bill project phases over time, apply deposits to invoices.
- Transfer any unused deposits to accounts receivable at project end.
Careful handling of different prepayment types avoids ambiguity and keeps the books clean!
Avoiding Common Mistakes with Prepayments in Accounting
Prepayments or advanced payments can create confusion in financial reporting if not properly recorded. Here are some tips to avoid issues:
Ensuring Revenue is Not Prematurely Recognized
- Resist temptation to recognize prepayments as revenue right away
- Defer income recognition until delivery of product/service
- Create liability account for unearned revenue
- Transfer to revenue only on delivery
Premature income recognition overstates revenue and profits artificially. This causes problems when filing taxes and financial statements.
Fulfilling Advanced Payment Obligations Reliably
- Link prepayments to required future delivery in accounting system
- Create reminders for staff to fulfill obligations
- Build alerts for prepayment expiration dates
- Automate where possible to reduce human error
It's critical to reliably connect prepayments to the associated delivery of goods/services. Otherwise obligations can unintentionally go unfulfilled.
Maintaining Visibility of Prepayments in Xero
- Use Xero's Prepayments/Repeating Invoices features
- Tag prepayments for easy identification
- Run Prepayments Tracker report frequently
- Reconcile prepayment accounts regularly
Keeping prepayments visible ensures they don't get lost or forgotten. Xero provides helpful accounting tools to track and manage advanced payments.
Following these tips will help avoid common prepayment pitfalls. The key is ensuring disciplined processes to record obligations accurately and fulfill promises reliably. This maintains proper books and keeps customers satisfied.
Concluding Thoughts on Prepayments and Xero
Accurately recording prepayments in Xero is critical for small businesses to maintain proper revenue recognition, cash flow visibility, fulfillment tracking, and financial reporting. There are two main methods for handling prepayments - manual journals and the Prepayments Tracker.
The Significance of Accurate Prepayment Tracking
- Prevents revenue from being recognized prematurely before goods/services are delivered
- Provides clarity into future cash flows as prepayments turn into revenue
- Enables order fulfillment teams to track outstanding balances and deliver correct orders
- Allows financial reports to show true accounts receivable and revenue figures
Choosing Between Manual and Automated Prepayment Methods
Manual Journals
- Simple but time-consuming to create monthly
- Prone to human error without automation
- Harder to track prepayment to invoice application
Prepayments Tracker
- Automated tracking as prepayments become revenue
- Links prepayments to invoices automatically
- More complex setup and management
Businesses should weigh the volume of prepayments and need for automation vs. simplicity.
Integrating Prepayments into Overall Business Operations
Reliable prepayment processing requires:
- Accounting to record prepayments accurately
- Operations to track outstanding balances
- Customer service to communicate status
With tight links between teams, prepayments can be smoothly integrated into financials and operations.
