GST treatment for prepayments and overpayments in Xero

One of our clients recently recently asked me to explain how GST works with prepayments in Xero. After I has answered the question via a lengthy email he replied:

“If you put this explanation on your website I think it would drive a lot of traffic.
I tried to Google my query to find an answer, and there’s nothing.”

So here it is …

Customer prepayments are usually coded to a current liability code in Xero with GST so the GST is recorded when the prepayment is received. Confusingly there is a chart of accounts code in Xero called Prepayments that is a current asset for expenses paid in advance – better names for these would be Income Received in Advance and Expenses Paid in Advance. However for the purposes of this article Prepayments will refer to a current liability code for customer prepayments (i.e. income received in advance of delivering the service/product) as that is what Xero call it on the reconcile screens.

Overpayments are a bit different and are discussed at the end of this article.

The specific question our client had was if a customer pays a deposit for a service to be provided, and the deposit is reconciled as a prepayment in Xero, is the GST on the deposit being counted twice when the customer is invoiced for the service? The prepayment is allocated to the invoice and the invoice is eventually paid. The steps to do this in Xero are detailed in our FAQ here.

A good question. I’ll answer this by way of a worked example of a $100 plus GST deposit on a $500 plus GST sale. In Xero behind the scenes following occurs:

Step 1 – Reconcile the deposit as a prepayment
When the $115 inc GST is received it is reconciled to the prepayment ledger code in Xero. Xero records it as:

  • CR Prepayments $100
  • CR GST $15
  • DR bank $115

If this was the first transaction in Xero then: Prepayments = $100, GST = $15 and Bank =  $115. 

Step 2 – Create and approve the invoice

  • CR Sales $500
  • CR GST $75
  • DR Accounts Receivable $575

Sales = $500, Accounts Receivable = $575, Prepayments = $100, GST = $90 and Bank = $115. 

Step 3 – Allocate the prepayment to part pay the invoice
When you allocate the prepayment to an invoice Xero reverses the original prepayment – the CR Accounts Receivable $115 is the part payment of the invoice.

  • DR Prepayments $100
  • DR GST $15
  • CR Accounts Receivable $115

Sales = $500, Accounts Receivable = $460, Prepayments = $0, GST = $75 and Bank  = $115. 

Step 4 – Reconcile the final payment from the customer

  • DR Bank $460
  • CR Accounts Receivable $460

Sales = $500, Accounts Receivable = $0, Prepayments = $0, GST = $75 and Bank  = $575. 

If you are registered for GST on a payments (cash) basis then $15 of GST is due in step 1 and the remaining $60 of GST is due in step 4. Total GST due $75.

If you are registered for GST on an invoice (accruals) basis  $15 of GST is due in step 1, another $75 in step 2 and -$15 in step 3. Total GST due $75.

Creating an overpayment in Xero codes it to Accounts Receivable (no GST). If the overpayment is refunded, the refund is created with no GST or if it is applied to an invoice the GST is recognised then. More information on handling overpayments in Xero in our FAQ here.