3 Steps To Recognize Advance Payments For Your Business

If you are a real estate general contractor, an advertising campaign agency, a yoga studio that charges membership upfront, or any business that receives payments before delivering goods/services, you will want to know how to recognize revenue the right way so your income statement doesn’t look out of whack!

Many of you may complain about the big fluctuation of revenue recorded from month to month at your business. Here is why your revenue changes so much:

When you sign a contract and receive an advance payment upfront, you record the entire revenue and your revenue spikes upward. But during the months when you deliver goods/services to your clients, you are not recording any revenue. At the same time, you are spending a lot of money on payroll, materials, etc., and therefore you have a big negative income. Using this cash method to recognize revenue doesn’t reflect the real revenue earned each month. How do you solve this problem?

Here are three steps to follow when recording and recognizing advance payments to reflect your real monthly revenue:

1 . Record advance payments as current liability under “unearned revenue” on the balance sheet.

After signing the contract and receiving the big lump sum payment up front, record the payment as “cash” received and “unearned revenue” under current liability on the balance sheet. By doing this step, you are showing that you haven’t earned all the revenue although you have already received the cash for it. You might ask, why is advance payment considered a liability? It is because you haven’t earned the revenue yet and you have the obligation and liability to deliver the goods/services to your clients in the near future.

2 . When the goods/services have been delivered, move the amount from “unearned revenue” from balance sheet to “revenue” on the income statement.

Now that you have done the work for your client, it is time to recognize your hard work as revenue on your income statement. Using a journal entry, you will transfer the amount earned from “unearned revenue” on the balance sheet to “revenue” on the income statement.

You might ask, how much of the revenue do you need to recognize each time? It depends on the amount of work you delivered. To simplify the calculation, you can do it as a percentage of the total revenue.

For example, say you have received the entire advertising revenue for your client’s campaign. You could use the project deliverable on the contract to estimate what percentage of work each deliverable is out of the entire project. From there, recognize the corresponding portion of the revenue when you finish each deliverable.

To summarize, after you receive the advance payment, you record the amount on the balance sheet as a liability; after you have delivered the goods/services, you move the payment to your income statement as revenue.

3 . Bonus step: if you want to track profitability by project and customer, turn on the “class” feature.

You have probably often wondered, which project makes the most profit for you? To uncover this mystery, you will want to track both revenue and expenses for all of your clients and projects. Start with turning on the feature in QuickBooks called “class.” Every time you receive or spend money for this client/project, tag that transaction with your client/project. Once that is done, you can run an income statement by class to find out the net income for each client/project. Voila! Now you know which client/project is your true hero!

Tax implication:

Each year you pay tax on the revenue you recorded on your income statement. For advance payments, you can delay recognizing the revenue until a later year IF the goods haven’t been delivered and services haven’t been performed yet, thereby reducing your tax payment amount for the current year.

Financial analysis:

Your investors and banks want to know that you are running a business with steady revenue. Smoothing the ups and downs of revenue by doing advance payment recognition will reduce investors’ fear of the instability of the business.

Takeaways:

For businesses receiving the entire payment upfront, you want to recognize it as unearned revenue until the goods/services have been delivered. By doing this, your revenue will stabilize and also your taxes will be recorded in a more reasonable way. As always, I hope this article is helpful and answered some of the questions you might have!