How to account for customer advance payments
/A customer may pay in advance for goods being delivered or services being provided. Possible reasons for a customer advance are noted below.
Customer Advance Due to Bad Credit
The seller is unwilling to advance credit to the customer and so demands payment in advance. This is most common when the amount of the sale is quite large, since extending credit would represent a substantial risk for the seller.
Customer Advance Due to 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. This is particular concern when the cost of the materials required to assemble the product is substantial, so the seller would incur a notable loss if the buyer were not to pay.
Customer Advance Due to Cash Basis Accounting
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. In this case, the customer may willingly pay early, with no prodding from the seller.
Customer Advance Due to 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. This is most common when there a constrained amount of capacity in the industry.
Related AccountingTools Courses
Accounting for a Customer Advance
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 as follows:
Initial recordation. Debit the cash account and credit the customer advances (liability) account.
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.
Presentation of Customer Advances
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. A sample presentation of a balance sheet that contains a customer advances line item appears in the following exhibit.
Example of the Accounting for a Customer Advance
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.
Related Articles
How to Account for Accrued Rent