Advances and loans: employees, contractors and third parties

Advances and loans: employees, contractors and third parties

In the daily operation of a business, not all the money that leaves the cash drawer is an expense or a purchase. Owners frequently hand money over in advance: they give an employee a salary advance, lend money to a worker who needs it, pay a supplier in advance because the supplier asks for a deposit before shipping the merchandise, or leave goods with an outside seller to be commercialized. In all these cases the money or the merchandise leaves the business, but the business does not lose its right: it expects to receive in exchange a future discount, a delivery of goods, a service or the return of the money. Until that right is fulfilled, accounting must not treat the delivery as an expense; it must record a receivable.

This lesson of the accounting manual explains how to record those outflows that are not expenses yet: the advance to an employee, the loan to an employee, the advance to a supplier or to an independent contractor and the merchandise handed to a third party to sell on behalf of the business. We will see the journal entry made when the money goes out, the entry made when the advance is applied, documented or repaid, a complete numerical example shown in tables and the most common mistakes to avoid.

An advance or a loan is not an expense yet

The first idea to fix is the difference between an expense and a disbursement. The disbursement is the outflow of money; the expense is the consumption of the benefit. When the business pays the rent for its premises, it immediately receives the right to use them for the month: there the disbursement and the expense happen almost at the same time. But when the business gives an advance, it has not received any good or service yet. The employee has not yet worked the days being paid in advance, the supplier has not yet delivered the merchandise, the borrower has not yet returned the money. Recording those deliveries as expenses would bring forward a cost that belongs to the future and would distort the profit of the period.

The correct treatment is to record the advance as a right of the business. In accounting terms, that right is a receivable, in other words an asset: something the business expects to turn into a future benefit, whether by getting the money back, by receiving the promised merchandise or service, or by reducing a debt it owed to that person. The account takes a different name depending on the case: advances to employees, receivables from employees, advances to suppliers or merchandise in the hands of third parties.

This way of recording follows the principle that accounting information must reflect the economic substance of transactions and not only their form. The form is an outflow of cash; the substance is that the business keeps a right. Double entry expresses it clearly: every time money goes out as an advance or a loan, a receivable account is debited and cash or the bank account is credited. When the right is collected, applied or repaid, the entry is reversed: what the business receives, whether money, merchandise or a smaller debt, is debited, and the receivable that is settled is credited.

Keeping this control has immediate practical benefits. At the end of the month, the owner can see in a single report how much business money is in the hands of other people, how much employees owe for advances and loans, and how much has been paid in advance to suppliers for merchandise that has not arrived yet. That information prevents surprises: without control, a forgotten advance becomes a double payment and an employee loan without follow-up becomes a silent loss.

Advance to an employee: salary advance or travel expense advance

The most frequent case is the salary advance. An employee asks for part of the salary before the regular pay date, or receives money in advance to cover the expenses of a work trip: transportation, lodging and meals. In both cases the business hands money over today and expects to recover it in the short term. How it is recovered depends on the internal policy of the business: in some cases the value is deducted from the salary when the payroll for the period is prepared, and in others the employee presents the receipts of the expenses incurred and the advance is settled against those real expenses. Each business defines its own policy and writes it down to avoid misunderstandings.

The entry at the moment of delivery is simple. The receivable account that represents the right of the business is debited and cash is credited, or the bank account if the transfer is made electronically:

• Debit: advances to employees, a receivable that grows with each advance delivered.
• Credit: cash or bank, which decreases by the outflow of money.

When the advance is deducted from the employee payroll, the account that records the obligation of the business with its staff is debited and the advances account is credited: the employee receives less money in the settlement and the right of the business is settled. When the advance was meant for travel expenses and the employee presents the receipts, the travel expense account is debited for the supported value and the advances account is credited. If the employee spent less than the amount received, the difference is returned in cash and that return is recorded by debiting cash and crediting the advances account.

A good habit is to keep written evidence of the agreement before handing the money over: a signed note stating the amount, the date and the way it will be recovered. No special form is needed; an orderly internal document that makes it possible to identify at any moment the pending balance with each employee and the reason for each delivery is enough.

Loan to an employee

The loan to an employee looks like the advance, but there is a difference in substance. The advance is applied against future salaries or against expenses that the employee documents, while the loan is repaid in money, usually in periodic installments agreed between the parties. The business lends a sum, the employee returns it little by little and the receivable decreases with each installment. The loan can carry interest or not, depending on the policy of the business; in this lesson we focus on recording the money lent and its recovery.

When the loan is disbursed, the entry is the following: the receivable from employees is debited for the amount lent and cash or the bank account is credited for the same sum. It is advisable to keep the advances account and the employee loans account separate so that money to be deducted can be distinguished from money to be returned in cash; if the business prefers a single account, it can keep a subsidiary record by employee and by concept that serves the same purpose.

When the employee pays each installment, the entry is the reverse: cash is debited and the receivable from employees is credited. With each installment the balance decreases until it reaches zero when the repayment is complete. It is recommended to keep a small record per borrower showing the date of the loan, the initial amount, the installments received and the pending balance. That record makes it possible to answer in seconds how much each employee owes the business and when the payment will be finished.

Both the advance and the loan demand vigilance. Experience shows that small forgotten balances are the most dangerous: collection is neglected, the employee changes duties or leaves, and the business loses track of the money. For that reason it is wise to review these accounts at least once a month and to collect or deduct old balances before they grow without control.

Advance to a supplier or to a contractor

Some suppliers ask for a deposit before manufacturing or shipping the merchandise, especially for special orders, costly materials or custom work. The same happens with an independent contractor who asks for money in advance to start a job or a service. In all these cases the business hands money over today in exchange for a future delivery. Until that delivery happens, the business has the right to receive it or to get its money back, and that right is recorded as advances to suppliers.

The entry when the advance is delivered is: debit the advances to suppliers account and credit cash or the bank account. Notice that no purchase account and no expense account is debited: there is no merchandise received and no service performed yet. The advances to suppliers account is an asset, a receivable in a broad sense, and it is presented in the balance sheet together with the other rights of the business.

When the supplier delivers the merchandise, the moment to apply the advance arrives. Suppose the business advanced two million and the supplier ships a purchase of five million. The purchase is recorded at its total value and the credit side is divided in two: the advance already delivered is credited and stops being a right, because the merchandise takes its place, and the remaining balance is paid in cash or stays as an account payable to the supplier. If the balance is paid in cash, the complete entry of the purchase has one debit for the total merchandise value, one credit for the applied advance and one credit for the money paid at that moment. In the numerical example section we will see this case with figures and in a table.

It is worth clarifying that the purchase is not recorded at the net value but at the total value, because the merchandise entering the business is worth that total and the inventory must reflect it. The advance does not reduce the cost of the merchandise: it becomes part of the payment for that same merchandise. Confusing these two moments causes frequent mistakes, because if the purchase were recorded only for the amount paid in cash, the inventory would be undervalued and the future profit would be miscalculated.

The same logic applies when the advance is given to an independent contractor. If part of a job is paid in advance, an advances account is debited and cash or the bank account is credited; when the contractor finishes the work or performs the service, the corresponding expense or cost is recognized and the advances account is credited for the applied value. The principle is always the same: first the right is recorded and later, when the benefit is received, the expense or the cost is recorded.

Money or merchandise in the hands of third parties

There is a fourth situation in which the business hands over resources that still belong to it: merchandise left with a third party to sell on behalf of the business. This is the case of the consignee or the outside seller who receives products on consignment: the merchandise leaves the warehouse, but it has not been sold and it still belongs to the business. For that reason, no sale is recorded and no income is recognized at the moment of delivery: only the place where the merchandise is stored changes, not its owner.

To control that merchandise, accounting uses a control account, which can be called merchandise in the hands of third parties or receivables from consignees. When the merchandise is delivered, that control account is debited and the inventory account is credited, so the total value of the business inventory does not change: one part stays in the warehouse and another part is with the third party, but both add up to the same total and the accounting records can show where each part is located.

Control does not end with the entry. The business must ask the third party for periodic reports: how much has been sold, how much remains in stock and how much money must be remitted. When the third party sells, the business records the sale in the normal way and removes the sold merchandise from the control account; when the third party returns merchandise, it comes back to the warehouse and the transfer is reversed. A periodic reconciliation between the report of the third party and the records of the business makes it possible to detect differences in time.

Some businesses also hand money over to third parties, for example a revolving fund given to an outside seller for management expenses or a deposit given as a guarantee. The logic is the same: that money still belongs to the business and must appear as a right until it is settled with receipts or returned. The golden rule is simple: every resource that leaves the business before the business has received its benefit must be recorded in an account that shows who holds it and how much it is worth.

Summary of entries by case

The following table summarizes the cases seen in this lesson with their two moments: the entry made when the money leaves the business and the entry made when the advance is applied, documented, collected or returned.

Numerical example: advance to a supplier

We close the lesson with a complete example. Rosa business needs merchandise worth five million and its supplier asks for an advance of two million to reserve the order. Rosa delivers the advance with a bank transfer. Two weeks later the supplier delivers the merchandise and Rosa pays the remaining three million in cash. The entries of the two moments look like this:

Look at the result of the second moment. The merchandise enters at its total value of five million, the advances to suppliers account is credited for two million and reaches zero, because the right has become merchandise, and the bank decreases by three million for the balance paid. In total the business disbursed five million, the same figure the merchandise is worth, and in the balance sheet the advance disappears while inventory grows by the full value of the purchase.

Common mistakes when recording advances and loans

To finish, let us review the mistakes most frequently made when handling these accounts:

• Recording the advance as an expense of the period. This is the most common mistake. It brings forward costs that belong to the future, increases the expenses of the month, reduces the profit and leaves the business without the account that would allow applying the advance when the time comes.
• Losing track of the loans to employees. If the installments are not recorded, the registered balance does not match reality, the business does not know how much it is owed and part of the money lent may never come back.
• Forgetting to apply the advances to suppliers when the purchase arrives. The result is paying twice for the same merchandise or recording purchases higher than the real value, with the resulting disorder in the accounts payable.
• Removing consigned merchandise from the records as if it had been sold at the moment of delivery. That brings income and profit forward: the business believes it sold what is still on the shelf of the third party and makes decisions based on wrong information.

The good news is that all these mistakes are avoided with simple discipline: record every delivery as a receivable, apply the advance when the merchandise or the service arrives, and review the balances of these accounts at least once a month. With that habit, the balance sheet will always tell you how much business money is in the hands of employees, suppliers and third parties. To keep learning the step by step of accounting records with practical examples, the accounting manual of Kardex Tauro accompanies you lesson after lesson, from the first purchase to the closing of the period.