In the modern-day business dynamic, many transactions are carried out on credit. This involves organizations purchasing goods and services on credit and selling goods and services on credit.
Credit basically refers to paying at a later date and getting goods and services earlier in advance.
This is a normal business practice and should be accounted for using proper accounting principles, laid out under the Accrual Basis of Accounting.
Definition of Advance to Suppliers
Advance to suppliers basically refers to the amount paid to suppliers in advance for goods and services to be purchased later.
In this regard, suppliers receive payment before they deliver the goods; hence, this transaction is supposed to be reflected in the financial statements.
Advance to Suppliers (also referred to as Supplier Prepayments) is similar in nature to any prepaid expense that a company incurs.
This implies that the cash payment is made earlier than the date when the product or the service is actually received.
There can be numerous reasons why companies might need to pay an advance amount to the suppliers.
These reasons are as follows:
- Suppliers often need a form of guarantee, before they start preparing for a particular order. An advance payment acts as a guarantee, giving the supplier surety that the buyer will not back out once the order has been placed.
- Suppliers often make credit-based decisions after inspecting the credit history, and credit report of the given buyer. If the buyer does not have an acceptable credit history, the supplier might ask for an advance payment to be safe from default payments.
- Suppliers choose to opt for advance payments in the case of customized orders. This is because they specifically produce the order for the respective supplier, so if the buyer backs out, they might not have anyone to sell that particular inventory to. Hence, they choose to get advance payments to mitigate the risk involved to get substantial surety.
Advance to suppliers is a very common business practice. It does not necessarily imply a negative connotation on the buyer’s part.
With some nature of work, order fulfillment cannot occur without customers’ advances. Therefore, organizations resort to such measures to streamline the order and subsequent fulfillment practice.
Classification of Advance to Suppliers
Advance to Suppliers is a payment made in advance for a service (or good) to be utilized at a later date.
Therefore, it is classified as a Current Asset.
By definition, a current Asset is a commodity possessed by the company, the utility of which is likely to be derived in the coming 12 months.
Current Assets are mentioned in their liquidity order on the company’s Balance Sheet.
As far as Advance to Suppliers is concerned, they fall in the same category, because this prepayment is likely to result in asset creation in the coming few months.
This advance is most likely supposed to be classified as an inventory (or some other fixed asset), once the asset is realized.
Therefore, it makes sense to classify Advance Payments to Supplier as a Current Asset. They are categorized under the same heading on the company’s Balance Sheet.
It must also be noted that Advance to Suppliers is only recorded as a Current Asset if the order delivery date is less than 12 months.
For long-term orders, Advance to Suppliers is supposed to be treated as a Non-Current Asset, because the utility derived behind the particular payment is supposed to generate benefits for a period longer than 12 months.
Hence, the categorization of Supplier Prepayment as Current or Non-Current Asset is purely contingent on the expected timeline at which the order will likely be delivered.
The reason why Customer Advance is treated as an Asset vest is on the grounds of the Asset Recognition Principle.
Asset Recognition Principle
Following the asset recognition principle, it can be seen that organizations are supposed to record assets in the financial statements once it is highly probable that future economic benefits are likely to flow into the organization as a result of the transaction carried out by the company.
Once the organization pays the supplier in advance, this advance will probably reap future benefits for the company in terms of added inventory, and higher profits.
Therefore, it makes sense for advance payment to suppliers to be classified as Current Assets, since it creates a likelihood of the business benefitting from it once the transaction is over and the purchase process is complete.
Journal Entries for Advance to Suppliers
Accounting treatment for Advance to Suppliers is similar to the accounting treatment for any prepaid expense.
When the advance payment is made to the suppliers, the following journal entries are created:
| Particular | Debit | Credit |
| Advance to Suppliers | xxx | |
| Bank | xxx |
Subsequently, once the purchase has been finalized, i.e. goods have been delivered, then the amount is transferred to the Balance Sheet as an Asset. The journal entry to record this particular transaction is as follows:
| Particular | Debit | Credit |
| Current Asset – (Inventory) | xxx | |
| Advance to the Suppliers | xxx |
In the case, the supplier cannot complete the order, and the advance amount is returned to the buyer, there is a need to reflect that in the financial statements too.
This is done using the following adjusting entry:
| Particular | Debit | Credit |
| Bank | xxx | |
| Advance to Suppliers | xxx |
The journal entry above shows the payment returned back to the buyer, in case of order cancellation, or any other unprecedented circumstance as a result of which the order could not be processed.
Example of Advance to Suppliers
The concept and accounting treatment of advance to suppliers is explained in the following illustration:
Henry Co. is a trading concern that purchases goods and sells them at its retail outlet. They purchase goods from Brighto Inc. and display them for furniture-related items in the showroom. For the year ended, 31st December 2019, they paid their furniture supplier $25,000 for the items to be delivered in July 2020.
Since the payments to the furniture supplier have been made in advance, it is classified as an Advance to the Supplier.
When the payment is made to the supplier, the following transaction is made:
| Particular | Debit | Credit |
| Advance to Brighto Inc. (Supplier Prepayments) | $25,000 | |
| Bank | $25,000 |
The journal entry above records the advance that is made to Brighto Inc. in lieu of the items that are to be delivered in July 2020.
Once these goods are received, they are then going to be classified as inventory in the Financial Statements.
Hence, once the furniture is received, the following journal entries are made:
| Particular | Debit | Credit |
| Furniture Inventory | $25,000 | |
| Advance to Brighto Inc. (Supplier Prepayments) | $25,000 |
The above journal entry shows the adjustment made once the order has been fulfilled and processed by the company.
It is not recorded as inventory upfront (when the advance has been made) because it cannot be categorized as items for resale.
Therefore, it would be incorrect to classify them as inventory before the inventory item has been received properly.
