Customer Deposits and Down Payments: How to Record Them So Profit Is Not Overstated

A wedding decorator takes 40 percent deposits for events three to six months ahead. In March, bookings pour in and 120 million arrives in the bank. The owner sees a wonderful month, hires two more staff and buys a new van. By July the events begin, the remaining 60 percent arrives slowly, and the costs of flowers, labour and transport all land at once. The business is short of cash in its busiest season. The March "profit" was never profit. It was customer deposits: money received for work not yet done.

What a deposit is

When a customer pays before you deliver, you have received cash and taken on an obligation. You owe them either the goods or service, or their money back.

In bookkeeping terms, that is a liability, not income.

• Asset up: cash.
• Liability up: customer deposits, sometimes called unearned revenue or advances from customers.

Nothing touches the profit and loss report yet.

When it becomes income

Income is recorded when you have done what the customer paid for.

• Goods: when delivered.
• A single service: when performed.
• A long project: in stages, as each stage is completed.
• A subscription or membership: month by month, as the period passes.

At that moment the liability falls and income rises.

Worked example: a product order

A furniture maker takes an order for a dining table at 12 million, with a 50 percent deposit.

10 March: deposit received.

Profit and loss: no change.

25 April: table delivered, invoice issued for 12 million.

Apply the deposit to the invoice.

The customer now owes 6 million.

30 April: balance paid.

The whole 12 million is April's income, alongside April's cost of making the table. Income and cost sit in the same month, which is what makes the profit figure mean something.

What goes wrong if you record it as income

• Profit is overstated in the month deposits arrive, and understated when the work is done.
• Decisions are made on a false number: hiring, drawings, purchases.
• Costs arrive later with no matching income, and those months look like losses.
• You lose track of what you owe. Nobody can say how much of the bank balance belongs to work not yet delivered.
• Tax may be affected, depending on your jurisdiction's rules.

The deposit register

Keep a simple list alongside the books.

Each month, the total of "balance held" must equal the balance of the customer deposits account in the books. If it does not, something was recorded wrongly.

The register answers three questions at any time:

• How much have we received for work not yet done?
• Whose money is it?
• When do we have to deliver?

Deposits and cash planning

The deposit is in your bank account, and it is not all yours to spend.

• Part of it will be spent on that order: materials, labour, delivery. Set it aside.
• Know your total obligation. If you hold 60 million in deposits, you have 60 million of work to deliver before that money is earned.
• Do not fund this month's expenses with next season's deposits, unless you have planned how the later costs will be covered.
• A rising deposit balance in a growing business is healthy. A rising balance with falling deliveries is a warning.

A useful discipline: keep a separate bank account or a clearly labelled reserve for deposits on orders not yet started.

Refunds

A customer cancels and is entitled to their deposit back.

No income was ever recorded, so none needs reversing. This is another reason to record deposits as liabilities: a refund is simple.

Forfeited deposits

Your terms say the deposit is not refundable if the customer cancels within a certain period, and they cancel.

You no longer owe the goods or the money. The liability ends, and the amount becomes income.

Use a separate income account so it does not distort your sales figure.

Three cautions:

• Your terms must say so, in writing, before the customer pays.
• Consumer protection rules in some places limit how much can be kept. A deposit kept should bear some relation to your actual loss.
• Tax treatment of forfeited deposits varies. Ask an accountant.

Partial delivery and stages

For long jobs, earn the income in stages.

A renovation of 100 million with a 30 percent deposit, in three stages of 30, 40 and 30 percent of the work.

• Deposit received: 30 million to customer deposits.
• Stage 1 complete: invoice 30 million, apply the deposit. Income 30 million.
• Stage 2 complete: invoice 40 million. Income 40 million.
• Stage 3 complete: invoice 30 million. Income 30 million.

Income follows the work. Each stage's costs sit beside its income.

Gift vouchers, memberships and prepaid packages

The same rule applies.

• Gift voucher sold: a liability until redeemed.
• Annual membership paid upfront: one twelfth becomes income each month.
• Package of ten sessions: one tenth becomes income as each session is used.

Vouchers and packages that expire unused are treated like forfeited deposits when your terms and the law allow.

Security deposits

A deposit held as security, such as for rented equipment, is different again. You expect to return it.

• Record as a liability.
• It stays a liability until returned.
• If you keep part for damage, that part becomes income, or offsets the repair cost.

Keep these in a separate account from order deposits.

Sales tax

Whether tax is due when a deposit is received or when the invoice is issued depends on the rules where you operate. In some systems, receiving an advance payment triggers the tax. Check with your accountant, and set up the deposit entry to match.

On the invoice and the quotation

Make the deposit visible to the customer.

Quotation:

• Total price.
• Deposit required: amount and due date.
• Balance due: when.
• Cancellation terms.

Final invoice:

• Total.
• Less deposit received on [date].
• Balance due.

A customer who sees the deposit deducted on the invoice does not have to ask whether it was counted.

Month-end check

1. List open deposits from the register.
2. Total them.
3. Compare with the customer deposits account. They must match.
4. Look for old deposits: orders long past their delivery date still showing a balance. Either the delivery was not recorded, or there is an unresolved order.
5. Compare the total with the bank balance. How much of the cash is spoken for?

Common mistakes

• Recording deposits as sales.
• Recording the full invoice as new income at delivery without applying the deposit, counting the deposit twice.
• No register, so nobody knows what is held.
• Spending deposits as if they were profit.
• Keeping deposits with no written cancellation terms.
• Mixing security deposits with order deposits.
• Old balances left sitting in the liability account for years.
• Ignoring the tax timing.

Tools

A spreadsheet register and correct entries are enough for a small business. Bookkeeping software that lets you record a customer payment in advance and apply it to an invoice later keeps the register and the books in step. Polynusa's bookkeeping records invoices and payments per customer in one workspace. See the pricing page.

Summary

A deposit received before delivery is a liability, not income. Record cash up and customer deposits up. At delivery, invoice the full amount, apply the deposit and record the income, so income and cost fall in the same period. Keep a register that matches the liability account each month. Refund from the liability, record forfeits as separate income only where your written terms and the law allow, earn long jobs in stages, and remember that the cash in the bank is partly spoken for.

FAQ

Is a customer deposit income?

Not when it is received. A deposit for goods or services not yet delivered is money the business holds on the customer's behalf, recorded as a liability. It becomes income when the business delivers what was promised. Until then, the business may have to return it.

How should a down payment be recorded in the books?

When received, increase cash and increase a liability account, often called customer deposits or unearned revenue. When the goods or service are delivered, issue the invoice for the full amount, apply the deposit against it, and record the income. The customer then owes only the remainder.

What happens in the books if a customer cancels and the deposit is kept?

If your terms allow you to keep the deposit and the customer cancels, the liability ends because you no longer owe the goods or the refund. The amount is then recorded as income, usually in a separate account for forfeited deposits. How this is treated for tax can differ by country, so confirm with an accountant.