How to account for customer advance payments

There are times when a customer may pay in advance of goods being delivered or services being provided. Possible reasons for a customer advance can include:

  • Bad credit. The seller is unwilling to advance credit to the customer and so demands payment in advance.
  • Custom product. A product may be so customized that the seller will not be able to sell it to anyone else if the buyer does not pay, so the seller demands advance payment.
  • Cash basis. The customer may be operating under the cash basis of accounting, and so wants to pay cash as soon as possible in order to recognize an expense and reduce its reportable income in the current tax year.
  • Reserved capacity. The customer may be paying in advance in order to reserve the seller's production capacity, or to at least keep it from being used by a competitor.

For these reasons or others, a seller may receive an advance payment before it has done anything to earn the payment. When this happens, the correct accounting is to recognize the advance as a liability, until such time as the seller fulfills its obligations under the terms of the underlying sales agreement. Two journal entries are involved. They are:

  1. Initial recordation. Debit the cash account and credit the customer advances (liability) account.
  2. Revenue recognition. Debit the customer advances (liability) account and credit the revenue account.

It is generally best not to account for a customer advance with an automatically reversing entry, since that will reverse the amount of cash in the following month - and the cash paid is still in the cash account. Instead, manually track the amount in the customer advances account each month, and manually shift amounts to revenue as goods are delivered or services provided. This may require the use of a separate step in the month-end closing procedure, to ensure that the status of each customer advance is investigated on a regular basis.

A customer advance is usually stated as a current liability on the the balance sheet of the seller. However, if the seller does not expect to recognize revenue from an underlying sale transaction within one year, the liability should instead be classified as a long-term liability.

For example, Green Widget Company receives $10,000 from a customer for a customized purple widget. Green Widget records the receipt with a debit of $10,000 to the cash account and a credit of $10,000 to the customer advances account. In the next month, Green delivers the custom widget, and creates a new journal entry that debits the customer advances account for $10,000 and credits the revenue account for $10,000.

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