When a customer pays you before you do the work or deliver the product, the cash is in your bank account but you have not earned it yet. A deposit on a custom order, a down payment on a job, a prepaid package, an annual plan paid up front: all of these are money you are holding against a promise.
Recording that money as income the day it arrives is one of the most common ways small business books go wrong. The month you collect looks unusually profitable, the month you deliver looks like a loss, and nobody can tell how much of the bank balance is truly yours. Here is how to handle deposits correctly.
Why a deposit is a liability
Until you deliver, you owe the customer either the work or their money back. That obligation is a liability, usually recorded in an account called Customer Deposits, Unearned Revenue, or Deferred Revenue. It sits on the balance sheet alongside other things you owe, such as credit card balances and sales tax collected.
When the deposit arrives, the entry increases your bank account and increases the Customer Deposits liability. Your profit and loss statement does not change at all, because nothing has been earned. When you complete the work or ship the product, you move the amount out of the liability and into income.
If you keep your books on a cash basis, ask your accountant how they want deposits handled. For tax purposes, advance payments follow their own timing rules, which may differ from how you track things internally. For running the business, though, treating deposits as a liability gives you a much truer picture of each month.
Applying the deposit to the final invoice
Say a customer pays a $2,000 deposit on a $6,000 job. When the deposit comes in, record $2,000 to the bank and $2,000 to Customer Deposits. When the job is done, invoice the full $6,000 as income, then apply the $2,000 deposit against that invoice, which clears the liability. The customer owes the remaining $4,000.
Most accounting software handles this if it is set up correctly: record the deposit as a payment into the liability account, or as a credit on the customer's record, and apply it when you create the final invoice. The mistake to avoid is recording the deposit as income and then invoicing the full amount without applying it, which counts the $2,000 as income twice and makes the customer appear to owe more than they do.
For prepaid plans and packages, the money is earned gradually. A $1,200 annual plan paid in January is earned at $100 a month, or as each session or service is used. A monthly entry moving the earned portion from the liability to income keeps both accounts accurate.
Refunds, forfeits, and keeping the balance honest
If a job is cancelled and you refund the deposit, the refund reduces the Customer Deposits liability and the bank account. It never touches income, because it was never income.
If your terms let you keep a deposit when the customer cancels, the forfeited amount becomes income at that point. Move it from the liability to an income account, ideally a separate one such as Forfeited Deposits, so you can see how often it happens.
Review the Customer Deposits account every month. Each dollar in it should tie to a specific customer and a job or order that has not been completed. Old balances nobody can match to anything usually mean a deposit was never applied to its final invoice, or income was recorded twice. Cleaning these up early is far easier than at year end.
Get deposits right every month
If deposits have been booked as income and your monthly profit swings around for no clear reason, the fix is a cleanup of the liability account and the invoices behind it.
Evolv Bookkeeping can sort it out with a cleanup at $199 for each month behind, finished in 2 days and guaranteed in writing. After that, we reconcile your books every month for $199 flat, with 1099 prep at year end. No contracts, cancel anytime. Get an instant quote on our homepage.