What it means
A business that takes payment before delivery holds money it has not yet earned. The customer has performed (paid); the business has not (delivered).
Until it does, the money is owed to the customer, in the sense that the customer is entitled either to the goods or, if they do not arrive, to the money back. Accounting records that position as a liability: cash increases, and a customer deposit (contract liability) increases by the same amount; no revenue, no profit.
When the business delivers, the obligation is discharged and the liability is released to revenue: the deposit becomes part of the sale. If delivery is partial, the release is proportionate.
If the customer cancels and the terms allow the business to keep the deposit, the forfeited deposit is recognised as revenue (or other income) at that point, since the business no longer owes anything. If the terms require a refund, the liability is settled in cash.
Interest is not usually paid on customer deposits, which is their attraction to the business. The forms are varied.
Order deposits (a percentage on placing an order for goods to be made or delivered later) secure the customer's commitment and fund the work. Progress payments on long contracts are advance payments for stages not yet performed and are contract liabilities until the stage is complete.
Subscription and membership prepayments are deposits for services to be provided over a period, released to revenue as the period passes. Booking deposits in travel and hospitality are held until the stay or event; some are forfeitable, some refundable, and consumer law often prescribes which.
Retainers paid to professionals are deposits against fees to be earned. Security deposits (a tenant's deposit against damage, a hire deposit against equipment return) are held to be returned less any deductions, and in many jurisdictions tenants' deposits must be held in a protection scheme or a separate account.
Utility and telecoms deposits from new customers secure payment of future bills. The financial benefits are substantial for businesses that can obtain deposits.
Working capital: a business taking 30% deposits on $10,000,000 of annual orders with a three-month production cycle has $750,000 of customer funding at any time. Commitment: cancellations fall sharply when customers have paid.
Credit risk: the exposure at delivery is the balance, not the price. Cash flow visibility: deposits taken are orders confirmed.
Businesses in furniture, construction, events, travel, education, software and professional services rely on them, and businesses that could take deposits and do not are funding their customers' commitments themselves. The obligations are real too.
Deposits must be recorded against the specific order or customer, so that revenue is released on the right delivery and refunds are correctly calculated. Refundable deposits are liabilities that may have to be paid in cash; a business that spends its deposits on operations and then faces cancellations can find itself unable to refund, which is a common feature of failures in travel, events and construction, and which is why some jurisdictions require deposits in certain sectors to be held in trust or protected by bonds or insurance.
Deposit terms should be clear about refundability, forfeiture and the circumstances of each. And large deposit balances distort the balance sheet's liquidity ratios (current liabilities are inflated by amounts that will be settled by delivery, not cash), which readers adjust for.
In practice
Real-world examples.
Example
A software company invoices annual subscriptions in advance and holds $8 million of deferred revenue, released monthly as the service is provided.
Example
A wedding venue takes a 25% non-refundable booking deposit a year ahead, funding its winter cash needs from the following summer's weddings.
Example
A landlord holds a tenant's $2,400 deposit in a government-approved protection scheme and returns $2,100 at the end of the tenancy after agreed deductions.
Think of it
“Customer deposits are advance payments-money received before you've delivered what was promised.
Formula
Calculation
On receipt: Debit Cash; Credit Customer deposits (contract liability). Revenue recognised: nil
On delivery: Debit Customer deposits; Credit Revenue (for the deposit amount); the balance of the price is invoiced or collected
On refund: Debit Customer deposits; Credit Cash
On forfeiture (customer cancels, deposit retained per terms): Debit Customer deposits; Credit Revenue or Other income
Working capital funded by deposits = Average deposit balance = Annual order value x Deposit % x (Average time from deposit to delivery / 12)
Worked example. A kitchen manufacturer takes a 40% deposit on order, 40% on delivery and 20% on installation. Average order $25,000; average time from order to delivery 10 weeks; annual orders $12,000,000.
Individual order: customer orders on 1 March, pays $10,000. Entry: debit cash $10,000; credit customer deposits $10,000. No revenue. Balance sheet shows the $10,000 as a current liability. The manufacturer buys materials and builds the kitchen through March and April, funded in part by the deposit. Delivery on 12 May: the manufacturer invoices $10,000 (the delivery instalment), recognises revenue for the delivered kitchen (the performance obligation for the kitchen is satisfied on delivery; installation is a separate obligation), releases the deposit: debit customer deposits $10,000, debit receivables $10,000, credit revenue $20,000 (80% of the price, being the kitchen); cost of sales for the kitchen recognised. Installation on 20 May: invoice $5,000, revenue $5,000 for the installation service. Total revenue $25,000 across two dates; the deposit was in the accounts as a liability for ten weeks and as revenue on delivery.
Cancellation: another customer orders on 1 March, pays $10,000, and cancels on 20 March before materials are cut. The terms provide that deposits are refundable less a $500 administration charge before cutting and non-refundable after. Refund $9,500: debit customer deposits $10,000; credit cash $9,500; credit other income $500. Had the cancellation come after cutting, the $10,000 would have been forfeited: debit customer deposits $10,000; credit revenue (or other income) $10,000, against which the cost of the cut materials, now scrap or stock, is recognised.
Working capital: annual orders $12,000,000 at a 40% deposit held for an average of 10 weeks: average deposit balance = $12,000,000 x 40% x 10/52 = about $923,000. The manufacturer's customers fund nearly $1,000,000 of its working capital at no interest; at its 8% cost of borrowing, that is worth about $74,000 a year, and it removes the need for most of its overdraft. Before the manufacturer introduced deposits, it had funded materials from its overdraft and had cancellation losses of about $150,000 a year on kitchens built for customers who changed their minds; cancellations after ordering fell from 6% to 1.5% once deposits were required.
Balance sheet reading: at the year end the manufacturer holds $1,100,000 of customer deposits within current liabilities of $2,600,000. Its current ratio is 1.1, which looks tight; but $1,100,000 of the liabilities will be settled by delivering kitchens for which the materials are in inventory and the margin is not yet recognised, not by paying cash. An analyst adjusting for this treats the liquidity as comfortable. The deposits also show that the order book is $2,750,000 ($1,100,000 / 40%), about ten weeks of production, which is disclosed as an indicator.
Protection: the manufacturer's trade association operates a deposit protection scheme; membership costs $6,000 a year and guarantees customers' deposits up to $15,000 if the manufacturer fails. Its consumer customers ask about it; its competitors who are not members lose orders to it. The scheme also requires the manufacturer to hold deposits in a designated account until delivery, which it does, keeping the working capital benefit within a disciplined structure.Case study
Seen in the real world.
A furniture retailer that made to order took 50% deposits and had grown to $30,000,000 of annual sales. Its deposits, about $3,500,000 at any time, were paid into its general account and spent on stock, wages and expansion; the company had never distinguished customer money from its own. When a supplier failure delayed deliveries by three months, cancellations rose, and the company found that it could not refund $900,000 of deposits on cancelled orders because the cash had been spent on the stores it had opened.
It stopped refunds, customers complained to the regulator, and the resulting publicity cut new orders by half. The company entered administration owing $3,100,000 of customer deposits, of which the customers recovered nothing as unsecured creditors; the administrator's report observed that the business had been solvent on paper throughout, because the deposits had been correctly recorded as liabilities, and insolvent in practice from the day it began treating them as cash it could spend.
The retailer that acquired the brand from the administrator introduced a rule that deposits are held in a separate account and released to the operating account only on delivery, joined a deposit protection scheme, and advertised both. Its finance director's comment was that a deposit is a liability that customers can call, and that a business which cannot meet the call has been borrowing from its customers without telling them.
Watch out
Common mistakes.
- Recognising deposits as revenue when received. They are liabilities until the goods or services are delivered, however non-refundable the terms.
- Spending deposits on operations without regard to the refunds that cancellations or delivery failures will require, which turns a working capital benefit into an insolvency risk.
- Failing to track deposits against specific orders, so that revenue is released at the wrong time and refunds cannot be reconciled.
Questions
People also ask.
Is a non-refundable deposit revenue when received?
No. It is a contract liability until the business performs or the customer's right lapses through cancellation. Non-refundability affects when a forfeited deposit becomes income, not the initial treatment.
Must customer deposits be held in a separate account?
In some sectors and jurisdictions (tenancy deposits, travel, certain consumer goods, client money held by professionals), yes, by law or scheme rules. Elsewhere it is good practice for refundable deposits and a protection against the business spending money it may have to return.
How do deposits affect the balance sheet?
They increase cash and current liabilities equally, which lowers the current ratio although liquidity is unchanged or improved. Readers adjust by recognising that the liability is settled by performance, not cash, and that the deposits indicate the order book.
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