Jaclyn Anku, ProAdvisor Training & Certification Leader: On today's episode of In the Know, we'll explore how to track prepayments made to vendors and QuickBooks Online with ProAdvisor and trainer Brittany Brown. She'll present an excerpt from the Expenses and Vendors course found in our newly reimagined QuickBooks Online Certification Level Two. Brittany will walk you through deciding which method to use using accounts payable, using other current assets, and reconciling and running reports.
So with that, let me turn it over to Brittany. Brittany, thank you for being here.
Brittany Brown: Thanks for having me, Jaclyn. I'm excited about this topic. Let's jump in. This is on how to track prepayments to vendors.
Clients often need to pay deposits or make prepayments to vendors before receiving goods or services. We deal with this all the time as a firm that's primarily focused on e-commerce brands. Our clients often have to make prepayments to vendors that they're ordering inventory from. And this can be kind of a complicated process to execute if you don't know what you're doing. And it can also be kind of a pain in the neck to keep track of.
I actually learned a lot as I was preparing for this presentation, on some great suggestions Intuit has that I think are really great workflows.
When our customers make prepayments to vendors, there needs to be a well-defined workflow to keep the books accurate. Here are some other situations where you might see this:
Let's say you're an interior decorator and you're going to make a purchase prepayment for some furniture for a customer; you're going to be incurring that expense upfront before you really have an opportunity to bill that customer, because you haven't really done any work for them. Or you might have a construction company that pays a large deposit to one of their large subcontractors. Again, you’re incurring costs upfront, before you really have the ability to create bills or have those payments run through your workflow the way they normally would.
Some other words you might use are “retainer,” “deposit,” “prepaid expense,” or something similar.
In this particular course, we're going to use the term “prepayment,” and it basically means “money that's paid in advance of the services being performed or the goods being purchased.”
So your first task, when you're deciding this, is to figure out which of these two methods you want to use in order to enter the prepayment vendors into QuickBooks. You can either record them using accounts payable, or you can use another asset account. What are the pros and cons of each of these?
First, when using the accounts payable method, you can track vendor prepayments by entering a bill or expense and coding it to the account “accounts payable.”
This then produces a credit on a vendor's account, thus decreasing the amount they're owed, which you can later apply to the bill. Basically, what you're doing is creating a negative vendor account (which is why we call it a “vendor credit,” but really it's a negative vendor account).
Now, one of the things I learned when I was going through school that kind of helps all of this make a bit more sense, is that a “negative liability” is the same thing as an “asset,” and a “negative asset” is the same thing as “liability.” Both of these are correct from an accounting perspective, because when we create a negative accounts payable, our other option is to create another current asset instead. We're basically creating an asset, but by using the accounts payable account, it can make it sometimes easier to link those two pieces together.
So, when you record the prepayment, you should—if you're going to do it all correctly and perfectly at the end of the year (and if you have accounts that have negative AP balance)—make a journal entry to reclassify that debit balance for prepayments for accounts payable to a prepaid expense asset account (that’s if it bothers you at the end of the year to have a negative AP). If you have a negative AP because the prepayments exceed what you then owe, that can look really bad on financials and some tax accounts; it might raise red flags. So even though it's “correct accounting,” you might not like the way it sits. This option of basically reversing it with a journal entry is a completely valid approach; you would basically reverse that journal entry on the first day of the year.
One of the ways to do this without having to create multiple line journal entries for multiple vendors that have negative accounts payable is to use one account called Accounts Payable Adjustment and use that one vendor account on the journal entry when reversing the entry.
Incidentally, this method does not necessarily conform to Generally Accepted Accounting Principles (aka GAAP) because of the fact that it creates the negative AP instead of the positive asset account. But again, it is actually correct accounting—it just doesn't quite look right.
When you're doing things like calculating current ratios, like I mentioned at the beginning, a negative liability is actually the same thing as an asset and hits those ratios in the same way. So if you don't have anybody looking over your shoulder who actually cares about that, you can skip this step if you want. The accounting is correct, it just doesn't look quite as nice.
The other option, if you have auditors that are going to push back on you, is to use the other current assets account.
In this scenario, you're going to track vendors’ prepayments by actually entering an expense or check or creating a bill and recording it to this other asset account (usually called something like “vendor prepayments” or, if you want to be more specific, something like “inventory prepayments” if that's what it's for). Then you can increase the balance until you are ready to pay the final bill; and then you reverse that balance against the AP that's created when the bill is actually created.
Now, I'm actually going to demo all of this, so if you're having a hard time following what I'm saying, hopefully that will help everything make a lot more sense.
The bill will then later be entered into the full amount of the goods and services, but we'll add a line for the amount of the prepayment. This will offset that same account used in the first transaction, and we'll reduce the total bill due showing only the final amount needing to be paid.
Now that was really a mouthful, so we're going to go to QuickBooks in just a minute to show you how this works. But before we go there, let's just look at a couple of final questions you should consider when determining which methods should be used:
You should be asking yourself questions like whether the financial statements are going to be needed by outside third parties (people like investors, or if you have to be audited). If anyone else is going to be looking at it, and if you know they’ll have an opinion about it, that might affect the decision you make.
Second, ask how often the client is making prepayments to vendors.
Third, ask how much the prepayments are (if they're a material or immaterial amount).
Fourth, ask how much time will pass between when those prepayments are made and when the work is being done or the services are being delivered. This, again, is sort of like a materiality question, like, is it a material timeframe? If we’re talking about a couple of days, maybe handle it differently than if you're talking about a long timeframe.
Lastly, ask what the total value of combined vendor prepayments are at the end of the year.
As a general rule of thumb, the accounts payable option may be acceptable if your client uses reports for management purposes only. In other words, you are not providing these financials to somebody else who might say, “Why is your vendor balance negative? That doesn't make any sense.” It actually does make sense, but might require a lengthy explanation that you might not want to give. So that's one reason to maybe go the other route instead.
Or, when the total amount of prepayment is not a material amount, it kind of doesn't matter. This method is best when clients only use vendor prepayments occasionally. And clients can also use this method if there's a short time between the vendor prepayment and the delivery of the goods and services. Otherwise, the other current asset method is likely to be the best fit.
One of the reasons I don't say “just default to the other asset approach” is because it can actually be kind of hard to keep track of which vendors are associated with prepayments, and to remember to go back and apply them against the bills. When using the accounts payable approach, that prepayment is already associated with the vendor in a way that's very easy to see when the rest of the process moves forward. So all things considered, the accounts payable method is probably easier to execute on, which is part of the reason why we say “consider this method unless you have a reason not to.” Because it is actually easier to execute in the books than the other method. But let's go into QuickBooks and look at what this actually looks like.
One of the things you might want to do, if you're going to be using this method, is turn on a setting that will help automate some of this. Let's go see what that looks like.
So, we're going to come here to the general gear setting and select “Account and settings.” This particular setting happens to be under “Advanced” (and then “Automation”). It’s here, where it says “Automatically apply credits.” So, if this isn't already on, I would expand this section and I would select it instead. But keep in mind that this actually applies to both the AP and the work AR workflow. So if that's not going to work for you on both sides, then maybe skip the automation and just do it manually instead.
Let's give ourselves a scenario. Let's say that we are pre-buying some furniture for a customer that we're doing some decorating for. I walk into the furniture store and I write a check (let's say I'm buying furniture from Computers by Jenny). We're going to go to “Checking” and then enter everything else. When we come down to the Category Details, instead of putting in the expense, I'm going to map this right to “accounts payable” and in the description, I'm going to say “pre-purchase for client.” And again, we really like the number 500, so we're just going to go with $500 under “Amount.”
So, the key to doing this correctly is this part here (listing “accounts payable” under Category Details). When you create this expense, you're going to go directly to accounts payable as the category that it's actually being billed to. Then you're going to create the bill afterward.
So, the person we're going to be paying is Computers by Jenny, and I'm going to say “save and close.”
At this point, we need to go and actually create the bill. Here’s a setting that might actually make this process easier for you.
Again, I'm going to come up here to the gear icon and select “Account and settings” and then go to the tab labeled “Advanced.” Under “Automation,” I'm going to look for “automatically apply credit.” If this weren't already on, then I would turn it on. But again, keep in mind that when I turn it on, it does apply to both the AR and the AP side of things. If that's not going to work for both workflows, then go ahead and leave that automation off and do it manually.
Now, let's say I'm buying inventory from Computers by Jenny. I have issued a $2,500 purchase order, and they are requiring me to give them a down payment as part of that. So down payment, retainer, prepayment, deposit—these are all basically the same thing.
I'm going to come here under “Category” and put “Accounts Payable” as the account. So normally if I were buying inventory, I would not code this to Accounts Payable. But in this case (I’m going to use the inventory example here because I think it's the one that has the most far-reaching financial ramifications), if I were to indicate that this was “inventory,” instead of “accounts payable,” I would actually be increasing my inventory balance, which is not correct. I've only put down a down payment on that inventory—I haven't actually received it, and I don't own the inventory right now, so it would actually be skewing my financials to code it to anything else. So in this case, I'd code this to Accounts Payable (I'm going to give it $800) and save it.
What I have right now is a prepayment to this particular customer. One of the things I want to show you guys before we move on is a report that will help us see the way that this is playing.
Here is my Unpaid Bills report. Underneath this particular customer that I just used, Computers by Jenny, I can see that I now have two payments (I entered another one before this training began). So I have two prepayments that have been made, but no bill that's been established. So as you can see, for this particular customer, I actually have a negative vendor balance, just like I said we would. First is this $500 prepayment and then this $800 prepayment, giving us a combined prepayment of $1,300.
For this account, if I were to just run a vendor aging balance, it would show a negative balance of $1,300. And that is why some people don't love this method; a negative vendor balance is normally a red flag—a sign that there’s a problem. But in this case, it's exactly right. They should have a negative vendor balance because I have overpaid for something I haven't even been billed for. But now, how would we complete the loop on this?
The best way would be to come here to “Bill” and enter the whole bill. So, let's say after a couple of transactions and a couple of prepayments, the relationship is complete and I'm actually sending them the full bill. I don't think I have a furniture option here, so I'm going to go with “equipment rental.”
So now I have a full $2,500 that is being billed. This is an actual bill. Had we not made any sort of prepayment activity, this would literally just be an “Accounts Payable” with the expense coded. However, because I do have a prepayment against this (let's go back and look at that report again), I can see that because I now have a bill that's been entered for this vendor, as well as the prepayment, their balance as a vendor will now reflect both sides of this. I'll see the increase of $2,500 for the bill that represents the entire transactional relationship, but I also now have these two prepayments. And I can see that I now have a net AP with this particular vendor of $1,200, which is exactly right.
So now, how am I going to close the loop on this? What I really want to be able to do is pay the bill, have those prepayments correctly applied, and have the history of this vendor relationship reflected correctly. In order to complete the process on this, I'm going to come here to this “New” button, and I'm going to click “Pay Bills.”
And now as I come into Pay Bills, I'm going to say, “I have this bill that I want to pay.” And you can see that—because I took that step to automatically apply it—it's now automatically applying these credits. If it wasn’t, I’d have to do this manually, but it's automatically applying this credit, and therefore the only remaining amount I have left to pay is this $1,200, which is correct.
Now let's go take a look at this report one more time. You can see all of that prepayment activity—the bill that we entered—is all netted against each other now. So when I went into that vendor to pay that bill, it automatically gave me the credit to apply.
That is why this particular approach can be a lot easier to manage—because that prepayment is already associated with the vendor. So when I create a bill for the vendor, QuickBooks already recognizes that that vendor had a negative balance because of the prepayments.
Closing the loop on that becomes a lot easier, versus the method I'm about to show you, which is using the asset account instead (which doesn't create kind of screwy results on negative AP balances). So, you know, auditors like it better, but it is actually harder to execute because of some of these other reasons, so this is a great option. If you don't have somebody looking over your shoulder who has an opinion about how it looks on your financials, you can see that this was very easy to keep track of, and it was very easy to manage from beginning to end.
Now let's take a look at the second method for tracking vendor prepayments, which is to record them to a vendor prepayment account (usually classified as an “other current assets” account). This will increase the balance in that account until your client is ready to pay the final bill. There's this nifty little trick you're going to use to apply that prepayment and reverse the prepayment as part of the bill so there's a great audit trail against it, but it can be a little bit harder to keep track of.
Let's jump into that and see what that looks like inside QuickBooks. In order to use this method, the first thing you need to do is make sure you actually have the account that's going to be used in order to track the prepayment. So, we're going to go to the Chart of Accounts, and I'm going to create a new account. I'm going to call this new account, “vendor prepayments.” And as I mentioned earlier, this is going to be an “Other current asset” account.
So this vendor prepayment is basically going to hold all the things that would classify as prepayments. Meaning that these services and these goods have not been delivered, but I have now made a payment of some kind on it. So, what will this look like?
After creating that asset account, the next thing I'm going to do is basically say, “Who am I planning on paying?” We favored Computers by Jenny last time. Let's use Books by Betsy. I'm going to indicate the account that I'm paying with, and then this is where I'm actually going to put in the vendor prepayments. So, I'm going to map this to the vendor prepayment account that I just chose.
I'm going to say “prepayment for order,” and I'm going to say this is a $600 prepayment. So I issue the money, the check goes out (whether I'm paying with a credit card or whatever). The key to this method is this part here, where this prepayment is made. I'm actually going to map it to this vendor prepayment account. Now, what will happen when I save? What will be the financial impact when I save this screen? My bank account—my checking account—will go down by $600, and this vendor prepayment asset account will actually go up. So, I will now have this transaction.
I will now have this $600 balance waiting to be used in the vendor prepayment account. I'm actually going to go back into this because I want you guys to get in the habit of thinking through the financial impact. I also think it'll make everybody who's watching this a much better accountant and bookkeeper.
So, when we hit “save” on that screen, we are creating the financials on the vendor prepayment account. If I do nothing with this, if I forget about it completely in the future, this asset called “vendor prepayment” will just sit there. And that’s part of the reason why this particular method can be a little bit more challenging—it is very common for people to end up with these prepayment amounts that are just sort of trapped here. One of the things we're going to talk about, as part of showing you this method, is how to actually reconcile information and make this less likely to happen. But just know you have now created a $600 prepayment that's just going to sit on your balance sheet unless you do something with it.
So, what do you need to do with it next? We finished the job with Books by Bessie and now she's billing us for the full amount. We're going to come in here and create the bill. This is where we would now indicate the true expense that's being used. So, let's say that we were hiring her as a bookkeeper, because that seems appropriate with the name Books by Bessie, and this is a $2,500 engagement.
Now, if I were to just save this right now, and if I were asking my class what the problem is here, the problem would be that I'm showing that I owe this individual $2,500. But this is not accurate, because I've already made a $600 prepayment that needs to be applied against this bill. But as you can see, one of the challenges that I mentioned with this particular process is that it's lost right now; I'd have to just remember that that prepayment is associated with this, and that this would now be the time for me to actually associate it. The system doesn’t know that, the way it did with the accounts payable method (remember, the system knew that I had a credit that needed to be applied). Instead, now I need to remember that I have a credit that needs to be applied, but when I do, here’s how this is going to happen:
I'm going to say “vendor prepayments,” and now I’m going to decrease this—it’s going to be a negative amount entered for $600. Now, this part is beautiful, from a financial impact perspective. Now I have an outstanding Accounts Payable of only $1,900, which is correct because I've already prepaid. Also, this transaction—this line item—now decreases that prepayment account, so if I were to go in and run a report on that balance sheet, I would see an increase and then a decrease into that very account.
So, this also removes that prepayment while associating that prepayment with this particular transaction. As long as I remember that I have a prepayment and I remember to apply it this way, it's a very nifty method that closes all the loops. The system just doesn't prompt you or remind you that you have a prepayment that needs to be associated with this, which is why this can be a little bit trickier to track.
In order to make this process a little bit more usable, there's a really great way to reconcile and some reports that could be used to help you keep this prepayment account clean. Then, clients can run a report to view any existing prepayments in QuickBooks. You would first reconcile this account using the vendor prepayment, and then filter the report. Before running the report, reconcile that Other Current Assets account in which those vendor prepayments are being recorded.
This account should be reconciled at least once per month to clear out any prepayments that have been fully applied. When reconciling that account, because you're not reconciling against a statement or anything like that, you're always going to enter its ending balance as zero, regardless of the actual balance( like, in that reconciliation screen). The account won't be marked as fully reconciled until it's completely used up and the transactions have offset each other. Using the zero amount here enables you to track the ins and outs. If the client has a large amount posted to a vendor prepayment account, but pays in small installments, the transactions won't clear until the prepayment is fully applied, and then they can clear the bill against those installments.
To track the open vendor prepayments, you can run a detailed transaction report for the vendor prepayment account, and customize it. Let's take a look at how to do this.
First, you're going to open a balance sheet and look for that prepayment balance account. Select the balance on the vendor prepayment account to open a detailed report. This is how you're going to identify what might still need some of your attention.
You're going to customize the report first by changing the report period to “all dates.” Under “group by,” you're going to select that “vendor” field. You're going to select the columns and adjust them by adding, removing, and reordering them as necessary. And from the filter option, you can open another filter and then select “cleared” and choose “uncleared” in the dropdown to only display the uncleared transactions in the report (they will be uncleared if you've done the reconciliation correctly, which we'll go over in just a minute).
Change the report title to “vendor prepayments” by overtyping the existing title. Then save this customization so you don't have to recreate the report every time you or your client wants to go back and look at that open balance. Clients can also use these customizations to get reports on other balance sheet accounts. This is a great method to use when the client needs to know what makes up the open balance. For example, I've seen people use this for employee advances and customer prepayments as well.
When ready, you're going to run the report. At the moment, you can see it's showing all prepayments—even those with a zero balance. I can see here that this one should be zeroed out because we had a prepayment and then we billed against it, so this one shouldn't be showing up.
To get the reports to show just open prepayments, we're going to actually reconcile the vendor payment account regularly.
The beginning balance should be zero here, and the ending balance should be zero. For the ending balance, you're going to enter that zero regardless of what the balance is on the balance sheet account. Really what we're looking for are the ins and outs, and we want them to balance against each other which is why we're going zero to zero. You're going to enter the reconciliation date (typically done monthly) and then you're going to start the reconciliation. Then you're going to mark any prepayments that have been fully used. That is the full amount of the retainer that has been applied and cleared. One will show the payment column, the other in the charge column. When all the fully used vendor premiums are cleared and the difference is zero, you're going to select “finish now.” We then see here money in, money out, money in, money out.
When these are exactly opposite of each other, which is what we're really looking for, we know things have been fully used and offset. You'll see it balanced to zero. This is why we use the zero balance, because we are basically balancing to zero every time we do this. Then you're going to say “finish,” because you have customized the vendor prepayment reports by adding a filter for Uncleared status, and when you then turn around and run this customized report, you will see that it only shows open prepayments, which is exactly what we want. We want to be able to say, “These are things that should still be on our radar. These are things we still want to be watching.”
And that's a wrap on how to track prepayments to vendors. Thanks for having me, Jaclyn.
Jaclyn Anku: Thank you, Brittany, for the presentation, and thank you for watching. Be sure to like, comment, and subscribe so that you don't miss a single episode. We'll catch you next time.
