Deposits and Prepaids: Money You Haven't Earned Yet
Why this matters
When a customer hands you a deposit before you start the work, that money lands in your bank account, but it is not yours yet. You owe the customer the work it pays for. Treat it as income too early and you will overstate how well the business is doing, pay tax on money you may have to refund, and spend cash you still owe. Understanding deposits keeps your numbers honest and your cash from lying to you.
What a deposit really is
A deposit (or prepaid, or retainer) is money received before the work is done. In accounting terms it is a liability, not income. A liability is something you owe. Until you do the work, you owe the customer either the finished job or their money back.
The moment you earn it changes everything. Income is recorded when you perform the work, not when the cash arrives. A deposit on a job you have not started is "unearned revenue" sitting on your books as a debt to the customer.
Think of it like this: a gym that collects a year of dues up front has not earned eleven of those twelve months. It owes the member access. Your deposit works the same way.
Why this trips up shop owners
Most small shops run on a cash-in-the-bank mental model. Cash comes in, the business feels healthy. That instinct fails with deposits in three ways:
- It inflates your apparent profit. A big deposit makes a slow month look strong. You feel ahead, ease off on selling, and the slump shows up later when there is no deposit cushion.
- It invites you to spend committed cash. That deposit is already promised to materials, payroll, and the work itself. Spend it on something else and you are short when the job actually runs.
- It can cost you tax. If your books call the deposit income the day it lands, you may owe tax on money you have not earned and might refund. Recording it as a liability defers the income to when the work is done.
How to handle it on your books
The clean approach has two steps.
- On receipt, record the deposit as a liability (unearned revenue or customer deposits). Cash goes up, and an equal liability goes up. No income yet, no profit yet.
- When you perform the work, move it to income. Reduce the liability and recognize the revenue on the invoice for the completed work. Apply the deposit against that invoice so the customer is billed only for the balance.
If a job spans weeks, recognize the deposit in proportion to the work completed, not all at once at the start. A deposit covering roughly a third of a multi-week job becomes income as each third of the work is finished.
Reading the deposit number
The total deposits you are holding is a number worth watching. A rising deposit balance is usually good, it means future work is booked and partly funded. But it carries a warning: every dollar of that balance is a promise. If deposits held are large relative to your monthly costs, you have meaningful obligations to deliver. If you ever had to refund a wave of them at once, could you?
A healthy shop keeps deposits roughly matched to the work pipeline they cover and does not treat the balance as spare cash.
Practical rules to live by
- Never count a deposit as profit. It is not profit until the work is done.
- Don't spend the portion already committed to the materials and labor of that specific job.
- Refundable vs non-refundable matters. A non-refundable deposit is still unearned until you do the work, but your refund risk is lower. Know which kind your contract specifies.
- Reconcile deposits to open jobs monthly. Every deposit on your books should map to a job not yet completed. A deposit with no matching open job is a sign of a bookkeeping error or a job that quietly finished without the deposit being applied.
References
- IRS guidance on advance payments and when income is recognized
- SBA small-business accounting basics on liabilities and revenue recognition
- Standard accrual-accounting practice for unearned revenue
- See related: Unbilled Work: The Hidden Cash Trap
- See related: Reading a Cash-Flow Statement: The Basics