How to Record Prepayments in Xero: Managing Advance Payments

Managing prepayments in Xero is crucial for accurate financial records. Prepayments are payments received before delivering goods or services, recorded as liabilities until obligations are fulfilled. Here's a quick overview:

• Prepayments vs. Overpayments: Prepayments are liabilities for future services, while overpayments are customer credits for extra payments.
• Recording Prepayments: Use liability accounts like "Prepaid Expenses" and allocate payments monthly using journal entries.
• Releasing Prepayments: Adjust liabilities when services are delivered or goods provided.
• Common Examples: Rent, insurance, and service retainers often involve prepayments.
• Best Practices: Use tracking categories, recurring journal entries, and dedicated liability accounts for clarity.

Feature	Prepayments	Overpayments
Classification	Liability on the balance sheet	Credit in sales invoices
Reconciliation	Manual journal entries	Auto-applied to invoices
Visibility	Transaction activity only	Aged receivables and customer reports
Refund Process	Manual journal reversal	Cash refund tool in Xero

Accurate prepayment tracking ensures compliance, avoids tax issues, and improves cash flow visibility. The following sections provide detailed steps and examples for managing prepayments in Xero.

Record a Prepayment from a Customer in Xero

What is the difference between overpayment and prepayment in Xero?

Understanding how overpayments and prepayments differ in Xero is key to keeping your financial records accurate. While they might seem alike, they serve different roles and are managed differently in the system.

Feature	Overpayment	Prepayment
Location	Appears in sales invoices/bills as credits	Recorded on the balance sheet as liabilities
Visibility	Shows in aged receivables and customer statements	Only visible in transaction activity
Reconciliation	Automatic through Xero's allocation system	Requires manual journal entries
Refund Process	Uses Xero's 'Make a Cash Refund' tool	Needs manual journal reversals

Overpayments

Overpayments act as credits that can be applied to current or future invoices for the same customer or supplier. For example, if a customer pays $1,500 on a $1,000 invoice, the extra $500 automatically becomes a credit. This credit is visible in their account, making it easy to allocate to future transactions or issue a refund.

Prepayments

Prepayments, on the other hand, are advance payments for goods or services that will be provided in the future. These are recorded as liabilities on the balance sheet until the goods or services are delivered.

When to Use Each

Xero suggests using overpayments when you want:

• Clearer visibility of customer credits
• Easier reconciliation processes
• Lower risk of unused credits

However, prepayments are better suited for expenses that need to be matched to specific periods, like insurance premiums or lease payments. These require structured tracking through liability accounts and proper allocation across the relevant periods.

Understanding these differences ensures you're recording transactions correctly. Next, we'll walk through how to handle prepayments in Xero.

How do you record prepayments?

Now that we’ve covered the difference between prepayments and overpayments, let’s dive into how to record prepayments correctly.

Setting Up Your Accounts

To start, make sure you’ve created these two accounts:

• Prepaid Expenses (1220) – Classified as an Asset
• Amortization Expenses (6280) – Classified as an Expense

Recording Prepayments

Here’s how to record a prepayment step by step:

1. Create the Prepayment
   Navigate to:
   Business > Invoices > Awaiting Payment > +New Prepayment
   Fill in the amount, payer details, and any project or client tracking categories.
2. Reconcile the Payment
   Match the payment using your bank feeds.

Allocating Prepayments Monthly

For recurring prepayments like rent or insurance, use repeating journal entries to manage the monthly allocation. Here’s what the entries look like:

Action	Entry
Initial Recording	Debit Prepaid Expenses, Credit Bank
Monthly Allocation	Debit Expense, Credit Prepaid Expenses

"Prepayments should not be processed in the same way as Overpayments - use credit balance adjustments to apply overpayments as payments to subsequent invoices." – Crystalynn Shelton, CPA & Xero Expert

Tracking and Reconciling Prepayments

Keep a close eye on your prepayments using Xero’s prepayment identifier. This helps ensure they’re allocated correctly across accounting periods.

A structured approach like this keeps your records accurate and ensures expenses match the right periods. We’ll explore specific examples, like rent and insurance, in the next sections.

How do I release a prepayment in Xero?

Once you've recorded prepayments as liabilities, you'll need to release them when goods or services are provided. Here's how to do it in Xero:

Step-by-Step Release Process

• Go to Business > Invoices
• Find the prepayments under the Paid (fully allocated) or Awaiting Payment (partial) tabs
• Open the transaction and click the 🗑️ icon next to the credited amount

This keeps the original transaction intact while unlinking it from the invoice.

Impact on Financial Reports

Releasing prepayments affects how they appear in your financial data:

Report Type	Effect After Release
Bank Reconciliation	Remains visible
Account Transactions	Still listed
Client Activity	Continues to show
Aged Receivables	Disappears until reallocated

Keeping Records Accurate

Use your tracking categories to monitor any changes to prepayments. This ensures clear documentation and an organized audit trail.

"Regular AR account reviews are essential after prepayment modifications to maintain accuracy and ensure proper reconciliation status" - G-Accon Reports Documentation

Always keep original receipts and journal entries for compliance purposes.

What is an example of a prepayment?

Prepayments come in various forms, and how they’re managed in Xero depends on the scenario. Here are three common examples:

Professional Service Retainers

For instance, marketing agencies might collect $5,000 deposits from clients, holding these funds in liability accounts until the work is finished. In Xero, this involves:

• Identifying the vendor or client clearly
• Specifying the service period dates
• Setting up an amortization schedule
• Reconciling payments to the original contracts

Subscription Services

When a business pays upfront for a yearly software license or membership, the total payment is spread out over the subscription period. As time passes, the prepayment is gradually converted into an expense.

Advance Deposits

Some businesses request deposits for custom orders or large-scale projects. These funds stay in a prepayment liability account until the product is delivered or the service is completed.

These examples highlight how Xero uses manual journal entries and tracking tools to manage different types of prepayments effectively.

Setting Up Prepayments Tracker in Xero

Once you've recorded prepayments, it's important to set up a system to track them accurately throughout different accounting periods.

Creating a Prepayments Account in Xero

Start by creating a dedicated Current Liability account in Xero. Add a 'Prepayments' liability account in the Chart of Accounts to keep advance payments separate. This account ensures accurate classification on your balance sheet and simplifies prepayment management.

Using Tracking Categories for Prepayments

Xero's tracking categories help you monitor prepayments across various areas of your business. Here's how they can be applied:

Category Type	Example Use for Prepayments
Project	Manage retainers tied to specific client projects
Location	Keep track of prepayment balances by region
Department	Monitor prepayments allocated to different departments

Set up your tracking categories before recording transactions to ensure consistency in allocation. This preparation also supports the release process for prepayments.

Automating Prepayments with Recurring Journal Entries

Automating prepaid expense recognition can make your accounting process much smoother. Go to Accounting > Journals in Xero to create recurring journal entries that allocate prepayments over the relevant accounting periods.

To make the most of automation:

• Schedule monthly journal entries to debit expenses and credit prepayments.
• Add service period details in the description fields for clarity.
• Review unallocated prepayments quarterly to ensure everything is on track.

How to Record Advance Payments in Xero

Depositing Prepayments into the Xero Account

To properly record advance payments, follow these steps to ensure your financial records stay accurate. Start by creating a placeholder bill coded to your "Supplier Payments in Advance" account. This keeps liabilities separate, aligning with earlier setup instructions.

For example, if a client makes a $5,000 prepayment:

• Create a placeholder bill in the "Supplier Prepayments" account.
• Attach any necessary documentation for reference.
• Reconcile the placeholder bill with the bank deposit.

Applying Prepayments to Invoices in Xero

To make tracking easier, use Xero's overpayment feature instead of traditional prepayment methods. This ensures prepaid amounts are visible in aged receivables reports and customer statements.

Action	Key Detail
Record Payment	Use the overpayment feature.
Apply Credit	Apply through credit notes.
Verify	Review in customer statements.

Managing Refunds for Unused Prepayments in Xero

If prepayments aren't used, handle refunds carefully by following these steps:

• Create a credit note that matches the prepayment amount.
• Reverse the entry in the "Supplier Prepayments" account.
• Process the refund using Xero’s refund tool.
• Attach necessary approvals for documentation.

"Overpayments highlight available credit that can be applied to open invoices, reducing the risk of them being overlooked."

For more complex cases, like multi-category allocations, use manual journals. This aligns with Xero’s guidelines and ensures prepayments are correctly reflected in your accounts.

How to Enter a Rent Bill as a Prepayment in Xero

Recording Rent Prepayments

Rent prepayments need to be handled carefully because they involve recurring payments and specific allocation schedules. Unlike insurance prepayments, rent prepayments often follow regular payment cycles and include lease-specific details.

To record rent prepayments in Xero, use the prepayment feature. Assign these payments to a 'Tenant Prepayments' liability account, and include lease details in the memo field. Make sure this dedicated liability account was set up during the initial configuration for tenant prepayments.

Step	Action	Important Note
Documentation	Record payment details	Include details like period and property
Tracking Setup	Apply property-specific category	Allows for filtered reporting

Allocating Rent Prepayments to Future Periods

To spread rent prepayments across multiple periods, set up recurring journal entries in Accounting > Advanced > Recurring Transactions. For example, a $12,000 annual prepayment can be allocated as $1,000 per month using these recurring journals.

"Xero should automatically reverse (or reduce) the Prepayment accounting entry and its GST sales tax entry when applied to final invoices." - Xero Central Support Team

To stay consistent with Xero's prepayment system:

• Create monthly allocation journals that align with the lease terms.
• Use tracking categories to filter reports by property.
• Regularly monitor activity using Account Watchlist reports.

Frequent reconciliation ensures any discrepancies are caught and corrected early, keeping your financial records accurate.

Adding Insurance Prepayments in Xero

Recording Insurance Prepayments

Unlike rent prepayments, insurance prepayments often depend on policy timelines and coverage specifics. In Xero, you can use tracking categories to align these prepayments with your system. Add custom fields like policy numbers and expiration dates to make tracking easier.

Include policy numbers and expiration dates in the tracking category descriptions for quick filtering. For example, separate policies like a $1,800 liability policy and a $600 property policy by setting up distinct tracking categories.

"Prepayments do not appear in client summaries of amount owed or aged receivable reports - alternative reports are needed for visibility." - Xero Integration Guide

Adjusting Insurance Prepayments Over Time

As coverage periods progress, insurance prepayments need regular adjustments. Xero's bank feed automation can identify recurring insurance payments, simplifying the allocation process.

Here’s how to manage them effectively:

• Assign payments to specific insurance prepayment accounts.
• Use tracking categories to differentiate between various policy types.
• Set up recurring journal entries that match the policy periods.

This approach helps keep your expense allocation accurate and provides a clear view of your insurance prepayment status throughout the coverage period.

Using Manual Journals for Prepayments in Xero

Creating a Manual Journal for Prepayments

Sometimes, automated features can't handle more complex prepayment situations. That's where manual journals come in handy - they give you the flexibility to allocate payments across different accounts or time periods. Before you start, make sure your chart of accounts includes a specific prepayment asset account and the necessary expense accounts.

It's important to add clear descriptions to your journal entries for a solid audit trail. For example: "2025 Professional Liability Insurance Prepayment - Policy #LP25789".

"Manual journals provide the audit trail needed for complex prepayment scenarios that automated features can't handle." - Xero Central Help Article

Adjusting Prepayments with Manual Journals

To adjust prepayments, create monthly journal entries that debit expenses and credit the prepayment account. If adjustments are needed mid-period, reverse the original entries before making changes.

Double-check your adjustments by:

• Reviewing the Balance Sheet each month to ensure the prepayment account is accurate.
• Verifying the Profit & Loss statement to confirm that expenses align with the correct timing.
• Using tracking categories to monitor prepayments by department, if applicable.

This manual method works alongside Xero's automated tools to help you stay accurate and compliant.

Reporting on Prepayments in Xero

Customizing the Aged Receivables Report for Prepayments

Once you've set up tracking categories for prepayments, Xero's reporting tools can help you keep an eye on them. While the default aged receivables report doesn’t show prepayments directly, you can use the Accounts Receivable Detail report instead. This method ensures you maintain the audit trail created through manual journal entries.

Analyzing Repeat Journal Reports for Prepayments

Monitoring prepayment recognition through journal entries requires consistent tracking. Tools like G-Accon's template designer allow you to create custom reports tailored to prepayment attributes for better insights.

Report Type	Purpose	Key Features
Accounts Receivable Detail	Track unapplied credits	Lists all available prepayment balances
Repeat Journal Report	Monitor recurring allocations	Highlights monthly recognition patterns

Building a Prepayments Dashboard in Xero

To create a useful prepayments dashboard, focus on tracking the right metrics. Key elements to include are:

• Total prepaid balances by client or vendor
• Comparison of unapplied credits and allocated amounts
• Reconciliation progress with bank transactions

"Regularly review your Accounts Receivable DETAIL report to maintain accurate AR by applying available credits to unpaid invoices promptly." - Poolwerx Xero Documentation

For a more detailed view, third-party tools like ScaleXP and G-Accon can provide visual timelines and comprehensive audit trails, going beyond Xero's built-in reports.

Best Practices for Managing Prepayments in Xero

Keeping a Dedicated Bank Account for Prepayments

Using a separate bank account in Xero for prepayments makes financial tracking easier and keeps transactions organized. To set this up, go to Accounting > Bank accounts > Add Bank Account and name it "Client Prepayments." Assign it a current liability account code (between 2200-2299).

This dedicated account ensures advance payments stay separate from operational funds, minimizing errors during reconciliation. It also provides a clear audit trail and helps you monitor expiration timelines by using Xero's custom fields.

Adding Expiration Dates to Prepayments

Once you’ve set up a separate account, use date-based tracking to manage prepayments effectively. Create custom tracking categories with specific date fields (like "PP-Expiry-2025-Q1") to keep tabs on expiration timelines.

Tracking Element	Purpose	How to Use
Date Categories	Track expiration dates	Use custom fields with quarterly codes
Automated Alerts	Avoid missed deadlines	Set reminders for 30, 15, and 0 days before expiration
Monthly Recognition	Monitor usage and allocation	Use scheduled journal entries

Setting Up a Refund Policy for Prepayments

A clear refund policy is essential and should work seamlessly with Xero’s features. Include these key elements: time limits (e.g., 14-day refund window), service completion thresholds (such as 50%), and proper documentation that aligns with Xero.

For partial refunds, use manual journal entries with debit/credit adjustments. For full refunds, process credit notes with negative prepayment lines. These methods ensure accurate tracking within Xero’s system.

Xero Tutorial: A Guide to Small Business Prepayments

Navigating the Prepayments Feature

Once you've set up tracking categories and liability accounts, here's how to handle prepayments in Xero:

If there's no existing invoice, head to Accounting > Bank accounts. For customer prepayments, choose "Receive Money." For supplier prepayments, select "Spend Money." Be sure to code these transactions to your prepayment liability account and apply the tracking categories you previously set up.

Using Xero for Prepayment Accounting

The tracking categories you created during setup come in handy for:

• Classifying Payments: Identify the type, such as rent, insurance, or deposits.
• Managing Timelines: Assign effective dates and track allocation statuses.
• Handling Multi-Currency Transactions: Use the multi-currency tracking categories configured earlier.

Keep an eye on prepayments with the reporting tools you set up. For partial prepayments, Xero's batch allocation tool simplifies things. For example, if you need to apply a $1,000 prepayment to several invoices, you can allocate specific amounts while keeping a clear record of the remaining balance.

Mastering Prepayments in Xero

Why Accurate Prepayment Tracking Matters

Setting up reliable systems for managing prepayments in Xero not only improves cash flow visibility but also ensures compliance. With features highlighted in the setup and reporting sections, businesses can efficiently allocate expenses while keeping detailed audit trails. This is crucial for maintaining both operational control and meeting regulatory standards.

Practical Tips for Using Xero's Prepayment Tools

To get the most out of Xero's prepayment features, here are some key strategies:

• Use the Accounts Receivable Detail report to spot unapplied credits and match them accurately with bank statements.
• Set up tracking systems and alerts to maintain control over advance payments and stay aligned with tax reporting requirements.
• Leverage scheduled journal entries, as shown in the Automation section, to streamline record-keeping and improve cash flow management.

Related Blog Posts

• How to Manage Bills in Xero: Streamlining Accounts Payable
• Managing Recurring Billing in Xero
• Recording Prepayments in Xero Made Easy
• How to Record Loans in Xero: Managing Debt Effectively