Before you read this, check out the posts What’s a prepayment and the types of prepayment and Debits and credits flows including GST that happen for a prepayment in the T-Accounts to get a more in depth understanding of how prepayments work on the whole.

In Xero to create a prepayment and then apply it to an invoice:

• Make a prepayment – to do this go to: account > bank > new > spend money/receive money (depending if it’s a prepayment to receive money or a prepayment to spend money. Use the ‘Revenues Received in Advance’ account for money received or ‘Prepayment’ for money spent.
  
• You’ll then need to reconcile to a bank statement line with the prepayment. Your prepayment will sit in your account as an ‘awaiting payment’ invoice in sales (if receiving money) or in purchases (if spending money).
  
• If you want to refund your prepayment, go to your prepayment, reconcile it and then cash refund the prepayment.
  
• Allocate your prepayment to a full invoice – after reconciling it, create your full invoice (use the same contact name), then a pop up box appears after approving the invoice asking you whether you want to allocate the prepayment to it.
  
• You can also allocate your prepayment to an existing invoice – go into the prepayment, prepayment options > allocate credit.