Customer deposits and unearned revenue
Cash you received before you did the work is a liability until you earn it.
General information, not tax or legal advice. When a deposit becomes income on a tax return follows the accounting method and the IRS rules for that method. This page is the bookkeeping entry, not that determination. Publication 334 is the small-business starting point for methods.
Why the deposit is not a sale yet
A client pays a $2,000 retainer on March 1 for work you will do in April. The bank balance goes up in March. If you credit revenue in March, the profit and loss claims you earned money you have not earned, and April’s profit disappears when you do the work and record nothing. On accrual books the March entry is a debit to cash and a credit to unearned revenue, which is a liability. In April, when you do the work, you debit unearned revenue and credit revenue. Cash does not move the second time.
The entries
- Receive the deposit. Debit cash. Credit unearned revenue or customer deposits. Do not credit service revenue.
- Do the work. Debit unearned revenue for the portion you earned. Credit revenue for that same amount. A half-finished retainer moves half, not all of it.
- Refund what you did not earn. Debit unearned revenue. Credit cash. Revenue stays untouched because you never recorded it.
- Leave sales tax out of the deposit account. If the later invoice includes sales tax, that tax is its own liability. The sales tax guide is the pattern. A deposit held for work is a different liability from tax held for the state.
Cash-method books still need a label
Under the cash method, income is often recorded when you receive it. A deposit can be income then, if that is your method. Even so, calling it “sales” when you might refund it hides the refund risk. Some cash-basis firms still park refundable deposits in a liability and only recognize nonrefundable receipts as income. That is a policy to write down and apply the same way every time, and it may or may not match the method on the return. The comparison is the bookkeeping difference. It is not permission to pick a tax method.
Unearned revenue is also not an owner’s draw and not a loan. If the owner lent the company money, use the owner-loan liability. If a customer prepaid, use the customer-deposit liability. Mixing them makes both the current liabilities and the owner’s equity wrong.
Sources
- IRS Publication 334 — accounting methods for a small business, including cash and accrual.