When a customer pays before you have supplied anything, you have their money but you have not earned it. Until the goods are delivered or the work is done, you owe either the supply or a refund. That obligation is a liability, so customer prepayments belong in a balance sheet account, typically called customer deposits or payments received on account, and not in sales.
Deposits for a kitchen fit, a wedding booking, a commissioned piece of furniture, or the first stage payment on a building job all fall into this account. Prepaid subscriptions spread evenly over a service period are a related but separate case, normally handled through deferred income.
Recording deposits
A kitchen fitter quotes £12,000 plus VAT for a job starting in six weeks and asks for 30% up front. The customer pays £4,320, which includes £720 of VAT.
For VAT, the deposit matters as soon as it arrives. HMRC’s VAT Guide (Notice 700) says a payment received before the basic tax point creates a tax point for the amount received, at the earlier of receiving the payment and issuing an invoice. Most deposits are advance payments under that rule, so the £720 belongs on the return for the period in which the money came in, even though the fitter has not yet started.
| Account | Debit | Credit |
|---|---|---|
| Bank | £4,320 | |
| Customer deposits | £3,600 | |
| Output VAT | £720 |
Issue a VAT invoice or receipt for the deposit that shows the VAT, so a VAT-registered customer can reclaim it and so the final invoice can deduct it. Businesses on the cash accounting scheme reach the same answer by a different route: VAT is due when payment is received, deposit or not.
Not every deposit creates a tax point. A refundable security deposit, such as money taken against damage to hired equipment and returned when it comes back intact, is not payment for a supply. Post it gross, with no VAT, to a separate security deposits account so it is never released to sales by mistake.
Turning the deposit into a sale
When the kitchen is fitted, the fitter issues the final invoice for the full £12,000 plus VAT, less the deposit already invoiced. The customer now owes £8,400 plus £1,680 VAT, or £10,080. The entry brings the whole sale into the profit and loss account and charges only the VAT not already declared:
| Account | Debit | Credit |
|---|---|---|
| Customer deposits | £3,600 | |
| Trade debtors | £10,080 | |
| Sales | £12,000 | |
| Output VAT | £1,680 |
Across both entries, output VAT totals £2,400, which is 20% of £12,000, declared in two periods. If the release is not made, sales are understated and the deposit sits on the balance sheet long after the customer has had their kitchen.
Where your software takes the deposit as an invoice in its own right, the final invoice will show the deposit as a deduction line. Check that the deduction is coded to the deposit account and not to sales, or the sale will be reduced twice.
Two ways a deposit can end without a sale
The customer cancels and you refund. Reverse the original entry. Notice 700 allows you to reclaim the VAT you declared on a refunded payment in your next return.
| Account | Debit | Credit |
|---|---|---|
| Customer deposits | £3,600 | |
| Output VAT | £720 | |
| Bank | £4,320 |
The customer walks away and you keep the deposit under your terms. The VAT you declared stays due; HMRC treats a retained deposit as payment for the supply that was not taken up. Move the net amount to income, often a separate cancellation income account so you can see how much it happens:
| Account | Debit | Credit |
|---|---|---|
| Customer deposits | £3,600 | |
| Cancellation income | £3,600 |
In the statutory accounts
The Companies Act balance sheet formats have their own line for this: payments received on account, under creditors falling due within one year (or after more than one year, if delivery is that far away). Small companies often combine it with other creditors in the published accounts, but your ledger should keep it separate.
A common problem at year end is customer money that arrived without an invoice and was left as an unallocated credit on the sales ledger. Trade debtors is then understated and the liability is hidden. Either raise a deposit invoice so the money sits in the deposits account, or move the balance there by journal. Unallocated credits that turn out to be overpayments rather than deposits are dealt with differently; see old customer credit balances.
A short monthly check
Keep a list of every open deposit with the customer, amount, date received and expected delivery date. At each month end:
- tie the list total to the deposits account balance
- release any deposit whose job has been completed and invoiced
- chase anything past its expected delivery date, because it is either an unbilled job or a refund waiting to happen
How deposits are requested and invoiced in the first place is covered in quotes, estimates and deposits. The VAT detail, including stage payments and continuous supplies, is set out in VAT on advance payments and tax points.