Down payment definition

What is a Down Payment?

A down payment is a cash payment made at the beginning of a purchase transaction. It is usually required by the seller of goods or services that are expensive and/or customized for the needs of the buyer. If the sale falls through, then the seller can keep the deposit and recognize it as revenue. The amount of a down payment usually approximates the material cost of the product being sold, so that the seller will not lose if the sale does not happen.

In the case of a lending arrangement, the down payment reduces the total interest expense for the borrower and provides some security for the lender, since someone who has made a down payment is less likely to default on the associated loan.

Accounting for a Down Payment

The recipient of a down payment (the seller) initially records the received cash as a debit to the cash account and credit to the down payments liability account. The entry is not initially made into a revenue account, since the seller has not yet earned the down payment. Instead, it is a liability of the seller. If the sale falls through, then the seller has earned the sale (assuming that the sale contract does not allow the buyer to retrieve the funds), so the seller can record a debit to the down payments liability account and a credit to the revenue account. Or, if the sale is completed in a normal manner, then the down payment is also reclassified as revenue using the same entry.

Example of a Down Payment

The purchaser of a car pays a distributor a 20% down payment for the vehicle, and takes a financing deal from the distributor for the remainder of the amount. As another example, a custom furniture manufacturer requires a 50% down payment on any furniture that it produces to custom specifications.