How do I handle deposits and advance payments in my accounts?

Understanding what “deposits” and “advance payments” really are

Deposits and advance payments are two of the most common sources of confusion in bookkeeping, especially for small businesses and growing teams. The confusion usually comes from a simple mismatch between cash movement and revenue recognition. Cash can arrive today, but the sale might not be complete until later. Accounting exists largely to describe that timing honestly and consistently.

In plain language, a deposit is money received (or sometimes paid) to secure an order, reserve capacity, or reduce credit risk. An advance payment is money received before you deliver goods or perform services. People often use the terms interchangeably, and in many businesses they behave similarly. From an accounting perspective, the key question is: have you earned the money yet? If you have not earned it, it is not revenue; it is a liability (something you owe in goods, services, or refunds) until you perform.

This article focuses on how to handle deposits and advance payments in your accounts, how to choose the right approach for your business, and how to keep your financial statements accurate without turning your bookkeeping into a weekly headache.

Why the accounting treatment matters

Handling deposits and advance payments correctly is not just about “doing it the right way.” It affects your profit, taxes, cash-flow reporting, customer balances, and the quality of your management decisions. If you record customer advances as revenue immediately, you may overstate your income in one period and understate it in the next. If you forget to track deposits as a liability, you may later struggle to reconcile why your bank balance looks healthy while your profit is flat, or why customer accounts don’t match the money you received.

Incorrect treatment also creates operational problems. Your sales team may believe you’ve hit a target because cash came in, while operations still owes months of work. Your finance team may pay tax on revenue that hasn’t truly been earned (depending on local rules and your accounting basis). And if you ever face an audit, investor review, or due diligence process, messy handling of deposits is one of those small issues that creates disproportionate distrust.

The big dividing line: cash basis vs accrual basis

Before you decide how to record deposits and advance payments, you need to know what accounting basis you use. Under cash basis accounting, revenue is generally recorded when cash is received, and expenses when cash is paid. Under accrual accounting, revenue is recorded when it is earned, and expenses when they are incurred, regardless of when cash moves.

Many small businesses start on cash basis because it feels intuitive and is easier. But as you grow, accrual accounting becomes more useful because it matches revenue to the period when you deliver value. Deposits and advance payments highlight the limitations of cash basis: cash arrives now, but the work may happen later. Even cash-basis businesses often benefit from tracking customer deposits separately because it improves clarity, prevents accidental double-counting, and helps you understand what you owe customers.

If you are required by lenders, investors, or regulators to use accrual accounting, the treatment is more strict: customer deposits and advances are liabilities until earned. If you’re on cash basis, you may still choose to track them as liabilities internally for better management reporting, while understanding that tax reporting may differ depending on your jurisdiction.

Key definitions you should align internally

A surprising number of accounting mistakes come from inconsistent internal language. It helps to define a few terms for your team and use them consistently across sales, operations, and finance.

Customer deposit (liability): Money received from a customer that may be refundable and is not yet earned. It often secures a booking, reserves inventory, or covers potential damage. Common in rentals, events, construction, and custom manufacturing.

Advance payment / customer prepayment (liability): Money received before goods/services are delivered. Usually applied against an invoice later. Common in subscriptions, retainers, pre-orders, and milestone-based projects.

Retainer (often a liability at first): Money paid upfront to reserve your availability. It becomes revenue as you provide services, either via time tracking or milestones, depending on the agreement.

Deferred revenue (liability): A formal accounting label for unearned revenue—often used for subscription contracts, annual maintenance, and prepaid service plans.

Security deposit (liability): Typically refundable, held to cover damage or non-performance. This should generally remain a liability until returned or legitimately applied under the contract.

The standard accounting approach for customer deposits and advances

In accrual accounting, the standard approach is straightforward:

1) When you receive the deposit or advance payment, you record it as a liability, not revenue.

2) When you deliver goods or perform services, you reduce that liability and recognize revenue for the portion earned.

3) If you refund any amount, you reduce the liability and reduce cash (or increase a payable if not yet paid).

This is conceptually simple, but implementing it smoothly depends on your invoicing workflow, the nature of your contracts, and your accounting software setup.

Journal entries: the simple patterns

Even if your software automates entries, understanding the journal logic helps you spot errors and train your team. Here are the most common patterns.

When you receive a customer deposit or advance

You receive money but have not yet earned it.

Debit: Cash / Bank

Credit: Customer Deposits (or Deferred Revenue / Unearned Revenue)

This entry increases cash and increases liabilities. Your profit does not change yet.

When you earn part or all of the deposit by delivering goods/services

You have now performed, so you can recognize revenue.

Debit: Customer Deposits (liability decreases)

Credit: Revenue (sales/income increases)

If only part is earned, you do this for the earned portion and keep the remainder as a liability.

When you refund a deposit

You return the money to the customer.

Debit: Customer Deposits (liability decreases)

Credit: Cash / Bank (cash decreases)

This is not a revenue reversal because you never recognized it as revenue in the first place.

When you apply a deposit to an invoice

Some businesses raise an invoice for the full amount and then apply the deposit as a payment or credit note. The accounting depends on the workflow, but the principle remains: the deposit is not revenue until earned.

Commonly, you issue an invoice when the sale is earned. The invoice creates accounts receivable and revenue. Then you apply the deposit against the invoice, reducing accounts receivable and reducing the deposit liability.

At invoicing (earned):

Debit: Accounts Receivable

Credit: Revenue

When applying deposit:

Debit: Customer Deposits

Credit: Accounts Receivable

This keeps revenue recognition tied to delivery, not to cash timing.

How to decide between “Customer Deposits” and “Deferred Revenue” accounts

Both labels represent liabilities. The best choice depends on how you want to report and manage information.

If you mostly take deposits for projects and jobs, “Customer Deposits” or “Deposits Received” is intuitive and helps operations see what is still owed. If you sell subscriptions, prepaid service plans, or long-term maintenance agreements, “Deferred Revenue” communicates that the liability will unwind over time as you deliver the service.

Many businesses use both:

• Customer Deposits: job-based deposits, security deposits, booking deposits

• Deferred Revenue: subscription prepayments, prepaid support, annual plans

This separation helps you analyze how much liability is refundable vs how much is simply unearned timing.

Security deposits: treat them carefully

Security deposits deserve special attention because they are often refundable and not intended to become revenue unless a specific event occurs (damage, breach, excess usage, etc.). A common mistake is to post security deposits directly to revenue or to offset them against costs without evidence that they are legitimately forfeited under the contract.

Good practice is to keep security deposits in a distinct liability account, such as “Security Deposits Held.” That way, you always know how much money you’re holding on behalf of customers. When the rental period ends and the deposit is returned, you reduce the liability and pay cash. If part is retained legitimately, you transfer only that portion into revenue (or to offset specific chargeable costs) at that time, with clear documentation.

Customer advances for inventory or custom work

When you take an advance for goods you haven’t delivered, the accounting is the same: record a liability until delivery. Where it gets tricky is when inventory is involved. If you buy materials after receiving the deposit, you may have a sense that the customer “funded” the cost, but that doesn’t mean you earned revenue. You still need to track inventory and cost of goods sold properly.

A clean approach is:

• Record the customer advance as a liability when received

• Record purchases to inventory or cost accounts as normal

• When you deliver, recognize revenue and cost of goods sold in the same period

This ensures margins are reported accurately and prevents profit from bouncing around based on cash receipts.

Advance payments to suppliers: the mirror image

So far we’ve focused on money received from customers. But the same logic applies when you pay suppliers in advance. If you pay for goods or services that you have not yet received, you typically record an asset (a prepayment) rather than an expense.

When you pay a supplier in advance:

Debit: Prepaid Expenses (or Supplier Deposits / Prepayments)

Credit: Cash / Bank

Then, when the goods/services are received and the cost is incurred:

Debit: Expense (or Inventory, depending on the item)

Credit: Prepaid Expenses

Again, the guiding question is: have you received the benefit yet? If not, it is not an expense. It is an asset.

Choosing the right workflow: invoice-first vs receipt-first

Accounting software often forces you into a workflow choice. Some businesses invoice first, then collect. Others collect first, then invoice. Deposits and advance payments commonly occur in “collect first” scenarios. The risk is that your system may automatically post receipts to revenue if you’re not careful.

To avoid misstatements, pick a workflow and document it:

Option A: Deposit request (sales receipt) then later invoice

• Record the deposit to a liability account

• Later, raise an invoice when earned

• Apply the deposit to the invoice

This is common for project work and bookings.

Option B: Pro-forma / deposit invoice then later final invoice

• Issue a deposit invoice that posts to a liability account

• Receive payment against it

• Issue a final invoice for full value when earned

• Apply deposit and collect remainder

This is common where customers require an invoice before paying.

Option C: Single invoice with split revenue timing

• For long-term service, you may invoice upfront

• Record cash received against deferred revenue

• Recognize revenue monthly or by milestones through adjusting entries

This is common for annual subscriptions and retainers.

No single option is “best” universally. The best workflow is the one your team can execute consistently, with minimal manual fixes, and with reporting that matches how your business operates.

Handling deposits on partially completed work

Many businesses deliver value over time. Think of construction projects, consulting engagements, software implementation, or manufacturing with multiple stages. You might receive a 40% deposit, perform 30% of the work this month, and the rest next month. The clean approach is to recognize revenue as you earn it, not when the deposit arrives and not only when the project is finished (unless your accounting policy requires completion-based recognition).

Practically, you can handle this through milestone invoicing or periodic adjusting entries. For example, if you track progress reliably (hours, deliverables, percentage of completion), you can recognize a portion of revenue and reduce the deposit liability accordingly. This keeps monthly statements meaningful and prevents big swings that hide performance trends.

If you do not have a reliable measure of progress, keep the deposit as a liability until the performance obligation is met, then recognize revenue at completion. The important thing is to choose a defensible policy and apply it consistently.

Sales tax / VAT considerations

Tax rules around deposits and advances can differ from your financial accounting treatment. Some jurisdictions require you to account for VAT or sales tax when you receive an advance payment; others trigger tax at the time of invoice or delivery. This means you might have a liability for unearned revenue and a separate liability for tax collected or owed.

Operationally, it helps to separate these components in your system. If you collect VAT on a deposit, the gross receipt includes tax that is not yours to keep, and you may owe it to the tax authority based on the rules that apply to you. If your software supports it, configure deposit products or deposit invoices with the correct tax treatment so the tax portion posts to your tax liability account, while the net portion posts to customer deposits/deferred revenue.

If you’re unsure, treat tax handling as a compliance topic: confirm how your local rules apply to deposits and prepayments, and then set up your bookkeeping workflow to align with that requirement. Even if revenue is deferred, tax may not be.

Refunds, cancellations, and forfeited deposits

Deposits become complicated when deals change. Customers cancel, reschedule, dispute, or partially complete. The contract terms matter: is the deposit fully refundable, partially refundable, or non-refundable after a certain point?

Fully refundable deposit: keep it as a liability until returned or applied to an earned invoice. If cancelled and refunded, you simply reduce the liability and pay cash back.

Partially refundable deposit: you may refund one portion and retain another. The retained portion should only become revenue when the contract terms allow you to keep it (for example, a cancellation fee). That retention is a business event that changes your obligation. When it happens, move that portion from the deposit liability to revenue (or to a specific “cancellation fees” income account if you want clearer reporting).

Non-refundable booking deposit: even if it is labeled non-refundable, it may still represent an obligation to deliver something (like reserving a slot). Many businesses treat this as unearned until the reservation period passes or the service date arrives. At that point, it becomes earned because you provided the reservation service, even if the customer does not show up.

The theme is consistent: revenue follows your performance and contractual entitlement, not the moment the customer pays.

Reconciling deposits: the habit that saves you months of pain

Deposits are easy to record and easy to forget. The way they cause problems is slow and quiet: a liability account that grows, old balances that never clear, customer names that don’t match, and invoices that were issued but never linked to the deposit. The solution is a routine reconciliation process.

At least monthly (weekly if deposits are a large part of your business), do the following:

• Run a report of your customer deposit/deferred revenue balances

• Identify older items (e.g., over 60 or 90 days) and investigate

• Match each deposit to a customer, contract, job, or order ID

• Confirm whether the work has been delivered and invoiced

• Apply deposits to final invoices or issue refunds where appropriate

• Document any forfeited deposits with the reason and contract reference

This reconciliation is not glamorous, but it’s one of the fastest ways to improve the reliability of your accounts.

Practical setup in your chart of accounts

A clear chart of accounts makes everything easier. Here is a practical structure many businesses use:

Liabilities

• Customer Deposits (short-term liability)

• Deferred Revenue (short-term liability; or split into current and long-term if material)

• Security Deposits Held (short-term liability, often clearly refundable)

• Sales Tax/VAT Payable (tax liability, separate from deposits)

Assets

• Supplier Deposits / Prepayments (current asset)

• Prepaid Expenses (current asset)

Keep deposit accounts distinct from accounts receivable. Deposits represent money you have already received but not earned; receivables represent money you have earned but not yet collected. Mixing them makes it difficult to understand your true working capital position.

Using products or items to automate correct posting

If you use accounting software with “products,” “services,” or “items,” use them to reduce manual errors. Create a “Deposit” item that posts to your Customer Deposits liability account, not to revenue. Then your team can issue deposit requests or sales receipts without needing to remember journal logic.

Similarly, if you take security deposits, create a “Security Deposit” item that posts to Security Deposits Held. For deferred revenue scenarios (like annual subscriptions), you may create an “Annual Plan” item that posts to deferred revenue, then recognize revenue monthly with a recurring journal entry or an automated revenue recognition feature if available.

The goal is not to create complexity; it is to bake correct behavior into your everyday invoicing so mistakes become rare.

Dealing with multiple currencies and payment processors

Deposits are often paid through card processors or online platforms. This introduces fees, timing delays, and sometimes currency conversion. A clean approach is to record the gross deposit as received and the processing fee as an expense (or net it depending on your reporting preference), but always keep the customer deposit liability accurate to what the customer paid and what you owe in value or refund.

If the processor deducts fees before the cash hits your bank, you can still record the customer deposit at the gross amount, then record a separate fee expense and a net cash receipt. This preserves the correct customer balance and lets you track payment costs properly.

For foreign currency deposits, keep an eye on exchange differences if you report in a base currency. The deposit liability might need revaluation depending on your accounting standards and materiality. Even if you keep it simple, consistently recording the currency and customer reference will help you unwind balances later without confusion.

Common mistakes and how to prevent them

Mistake 1: Recording deposits directly as sales revenue. This inflates profit early. Prevent it by using deposit items that post to a liability account and by training staff to use the right form or workflow.

Mistake 2: Leaving deposits unlinked to jobs or customers. This creates “mystery money” that never clears. Prevent it by requiring a customer or job reference on every deposit receipt.

Mistake 3: Applying deposits twice (once as revenue, then again as payment). This can happen when someone posts a deposit as sales and later applies it to an invoice. Prevent it by ensuring deposits are never posted to revenue until earned.

Mistake 4: Mixing security deposits with advance payments. These are different obligations. Prevent it with separate accounts and clear contract terms.

Mistake 5: Forgetting to handle VAT/sales tax correctly on deposits. You might owe tax even if revenue is deferred. Prevent it by configuring tax settings for deposit items and reviewing rules that apply to your business.

Mistake 6: Not reconciling deposit liabilities regularly. Old balances accumulate and become painful. Prevent it with a monthly deposit reconciliation routine and an “aging” review of outstanding deposits.

How deposits affect your financial statements

Understanding how deposits show up in your reports helps you interpret performance. On the balance sheet, deposits and deferred revenue appear as liabilities. This means high deposits can make your business look more “leveraged” even if you have strong cash, because you have an obligation to deliver. On the income statement, deposits do not appear until they are earned and recognized as revenue.

On the cash flow statement, deposits are part of operating cash flow because they represent cash received from customers. This is why cash can look strong even when profit is modest—your business might be funded by customer prepayments. That can be a healthy model (subscriptions, retainers) but it also creates responsibility: you must deliver in the future, and if cancellation rates spike, your cash advantage can reverse quickly.

Deposits and management reporting: making it useful, not just compliant

Compliance accounting tells you what happened. Management accounting helps you run the business. Deposits are a powerful indicator of future workload and demand. If you track deposits well, you can answer questions like:

• How much work have we sold but not delivered?

• What is our backlog measured in cash commitments?

• Are we relying heavily on customer prepayments to fund operations?

• How much is refundable (security deposits) vs tied to planned delivery (deferred revenue)?

• What percentage of deposits convert into completed sales vs cancellations?

These insights help with staffing, inventory planning, and cash management. To make reporting useful, consider segmenting deposits by product line, job type, or expected delivery month—only if your team can maintain it without friction.

When to recognize revenue from advances: practical examples

Example 1: Event planner booking fee

You take a booking deposit to reserve a date. If your contract states the deposit pays for the reservation service and is non-refundable after a certain point, you might recognize revenue when the date is reserved (or when the non-refundable condition is met), because the reservation service has been delivered. If the deposit is simply an advance against the full event fee, you recognize revenue when you deliver the event services and reduce the deposit liability at that time.

Example 2: Annual subscription paid upfront

A customer pays for 12 months. You record the cash as deferred revenue, then recognize 1/12 each month as revenue as you deliver access.

Example 3: Construction project with milestones

You receive a 30% deposit. You recognize revenue at each milestone when that stage is completed and accepted, moving amounts from customer deposits into revenue.

Example 4: Custom manufacturing with a refundable deposit

If the deposit is refundable until production begins, keep it as a liability. Once production starts, the deposit may become non-refundable. You still might not recognize it as revenue until you deliver, but you now have contractual entitlement to retain it if cancelled. Depending on your policy, you may treat any forfeited portion as income at the cancellation point.

How to keep your accounts clean when you have lots of small deposits

Businesses like salons, clinics, short-term rentals, and reservation-based services often have high volume deposits. The challenge is scaling the bookkeeping without losing accuracy. A few practices help:

• Use a dedicated “Deposit” item mapped to a deposit liability account.

• Require automated customer identification (email/phone/order ID) at payment time.

• Integrate your booking/payment system with your accounting software if possible.

• Reconcile deposits to bookings weekly, not quarterly.

• Use a standardized policy for no-shows and cancellations, and record forfeitures consistently.

• Keep a simple deposit aging report so old balances are investigated early.

When volume is high, the best system is one that prevents errors at the point of entry. Fixing mistakes later at scale is expensive and frustrating.

Internal controls: small steps that prevent big problems

Deposits are a natural target for confusion and sometimes fraud because money comes in before there is an invoice, and refunds may happen later. You don’t need a large finance department to apply basic controls:

• Separate who records deposits from who approves refunds, where possible.

• Require documentation for refunds or forfeitures (booking ID, contract clause, customer communication).

• Lock down who can edit posted transactions in your accounting system.

• Review deposit liability balances and old items monthly.

• Ensure bank reconciliations are completed on time, every month.

These steps protect your customers, your reputation, and your financial reporting integrity.

What to do at month-end and year-end

Month-end is when deposit handling either stays tidy or spirals. A good close process includes:

• Reconciling the deposit and deferred revenue accounts to supporting detail (customer-by-customer listing)

• Reviewing deposits received near month-end to ensure they weren’t incorrectly recognized as revenue

• Recognizing revenue earned from prepayments (subscriptions, retainers) for the month

• Checking for cancellations and refunds that should reduce liabilities

At year-end, add an extra layer:

• Confirm whether any deferred revenue should be classified as long-term (earned beyond 12 months) if your reporting requires that distinction

• Ensure security deposits held are accurate and supported

• Review big customer contracts to confirm revenue recognition aligns with your policies

• Make sure outstanding deposits are real obligations, not bookkeeping leftovers

A well-maintained deposits process makes year-end far less stressful and reduces the risk of late adjustments.

Putting it all together: a simple policy you can adopt

If you want a practical policy that works for most service and product businesses, start with this:

1) Any money received before delivery is recorded as a liability (Customer Deposits or Deferred Revenue).

2) Security deposits are recorded in a separate liability account and only become income if legitimately forfeited.

3) Revenue is recognized when goods are delivered or services are performed, using milestones or monthly recognition for ongoing services.

4) Deposits are applied to invoices when earned, not used to inflate revenue at receipt.

5) Deposit liability accounts are reconciled monthly, with older items investigated and cleared.

This policy is easy to explain, easy to train, and flexible enough for most real-world scenarios.

Final checklist for handling deposits and advance payments confidently

Use this checklist to review your setup and habits:

• Do you have clear accounts for Customer Deposits, Deferred Revenue, and Security Deposits Held?

• Are your deposit “items” or invoice lines mapped to liability accounts, not revenue?

• Can you tie every deposit to a customer and a job/order/contract reference?

• Do you have a consistent rule for when deposits become earned revenue?

• Are cancellations, refunds, and forfeitures documented and posted correctly?

• Do you reconcile deposit liabilities monthly and review aging?

• If VAT/sales tax applies to deposits, is your system configured accordingly?

When you can answer “yes” to these, deposits stop being a bookkeeping nuisance and start becoming a useful signal of demand and future work—while your financial statements remain accurate and trustworthy.