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and Customer Deposits
of the Balance Sheet
by John Cassis
Wouldn’t it be nice if we could take a look at a company’s
present on a business’s balance sheet. The two are often
balance sheet and have an idea what its near-term future
used interchangeably. However, deferred revenue requires
would be? Several familiar accounts already allow us to do
application of accurate accrual-based financial statements,
just that. Growth in receivables and inventory might hint
whereas customer deposits have been known to appear on
at what the first few months of the following year will be
both cash-based and accrual-based financial statements.
like, though more often these items move in tandem with
This article will explore what deferred revenue and cus-
historical sales. Meanwhile, a substantial increase in fixed
tomer deposits are, how they are created, and how they
assets or goodwill might suggest that new revenues from
can be analyzed to peer into a company’s future.
an asset purchase are in the company’s future. This article
will look at two items on the liabilities side of the balance
sheet that have some predictive qualities: deferred revenue
Customer deposits are created when a business asks its
(also known as unearned revenue) and customer deposits.
clients to place on deposit a percentage of the price of the
Deferred revenue and customer deposits are not always
product or service that has been ordered. They almost
always take the form of cash payments at the time a con-
resent—protection from contract default, cash to defray
tract is signed or an agreement to do business is reached.
initial costs, or something else?
The deposit may or may not be refundable, depending
As with all things on the balance sheet, it takes a gen-
on the purpose of that deposit. Contractors and certain
eral journal entry for the item to be reported. The most
professional firms originate a similar account called bill-
common journal entry involves a debit for cash and a
ings in excess of costs.
credit for the customer deposit. When the business finally
There are various reasons why a company may want to
recognizes the sale, the customer deposit account will be
collect customer deposits:
eliminated with a debit, and that amount will ultimately
• The company has never dealt with a particular custom-
be transferred to revenues with an offsetting credit.
While the origination of the customer deposit might
• The product or service purchased is to be customized,
seem obvious, its destiny is much less certain. If the de-
and the nonrefundable deposit serves as assurance that
posit were to remain in the form of cash, the banker’s job
the buyer will follow through on the purchase.
would be easy. With every dollar of customer deposit, one
• The company seeks protection from credit risk when
would then expect to see at least that amount of cash on
installment payments follow (such as with utilities or
hand. Some companies might go so far as to segregate cus-
rental real estate).
tomer deposits into a separate bank account and/or into a
• The company must incur substantial up-front costs to
“restricted cash” account on the balance sheet. More often,
provide the product or service purchased and expects
though, it becomes a challenge to determine what the busi-
the customer to finance a part of the cost.
ness has done with those deposits. Potential uses of cus-
When customer deposits of substantial size are spot-
tomer deposits will be discussed later in this article.
ted on a borrower’s balance sheet, it is a good idea for
the banker to ask a few questions about them. Does the
company have a policy for requiring customer deposits?
When a business collects all or part of a sale prior to
And if so, what is that policy? Has the company always
that product or service being delivered, the accounting
collected deposits, or are they a recent development? If
method used will determine how the company records
they are recent, then why? What does the deposit rep-
that transaction. In cash-based accounting, the sale is
As with all things
on the balance sheet,
it takes a general journal entry
for the item to be reported.
The RMA Journal February 2009
recognized at the time the cash is collected; thus, de-
to zero by the end of the period over which the sale is
ferred revenue will never be recorded. In accrual-based
earned. Note that while customer deposits will usually be
accounting, revenue can be recognized only when
eliminated all at one time once the product or service is
earned, regardless of when the cash is collected. As a
delivered, the unearned revenue is gradually reduced with
result, when sales proceeds are received in advance of
the passage of time.
revenue being earned, the business must recognize that
collection of cash as deferred revenue.
Deferred revenues are conceptually very similar to
When customer deposits or deferred revenues exist, they
customer deposits, and
tell us how much cash the business has collected from
in some cases they are
its customers for orders already placed. These are orders
When customer deposits treated as one and the
that will be converted to sales in the near future. Thus, in
are the exception rather same. Both are recorded
the absence of a backlog report, these two accounts can
than the rule, it is then
when cash is received
point to how much pending revenue has been received by
from a client in ad-
the business. If we know that a company’s practice is to
unusual for customer
vance of the sale, both
always collect 10% of the sale up front, we then divide the
deposits to represent
are generally received
amount of the customer deposit by 10% to arrive at the
at the time the order
amount of revenue that will be earned at the start of the
a significant portion
is placed, and both
next reporting period.
of total footings.
should be reflected as
If we know that the company we are analyzing applies
operating items in the
its deposits/deferred revenue policy uniformly to all its
cash flow statement. Companies sometimes use the two
customers, and that it has been doing so for some time,
we can further compare the balance in the current period
Whereas customer deposits are usually determined as
to those of prior periods. For example, all other things
a percentage of the total sales price, deferred revenues are
being equal, if customer deposits are 20% higher than a
usually collected based on time increments. For example,
year ago, we have now been given reason to believe that,
a warranty service company might require prepayment of
as of this point in time, revenues for the coming year are
a full year’s worth of service in advance, thus recognizing
likely to increase by 20% as well. There is no assurance
a full year’s deferred revenue upon collection of the cash.
that revenues will continue for the full year at the elevated
Similarly, an apartment owner might require payment of
levels, but the initial indication is that they will.
one month’s rent in advance. Deferred revenues are most
Note that this conclusion depends on two important
commonly associated with service companies, whereas
customer deposits are frequently associated with produc-
1. The customer deposit policy applies uniformly to all
ers of goods, services, or both.
Like customer deposits, deferred revenue is collected
2. This policy has been applied consistently over all the
in advance for a variety of reasons. Most commonly, it is
periods being analyzed.
established industry practice to require payment in ad-
These two assumptions do not always hold; however,
vance of the product or service. Mail-order businesses
the only way to be sure is to know the company and/
often require payment prior to shipment of a product,
or to ask the question. Sometimes it is revealed that the
and insurance companies often require all or part of the
company began a policy of requiring customer deposits
premium for the insured period to be paid in advance.
only recently, in which case the banker will want to ex-
As in the case of customer deposits, while there might
plore if this move was necessitated by the need for cash
be other issues necessitating early payment, such as pay-
or working capital. When it is discovered that the policy
ment default risk or up-front costs, most often it is in-
is not applied uniformly to all customers, then the predic-
dustry practice that results in deferred revenue. It is also
tive abilities of the customer deposits account diminish.
most common to require that all customers—not just the
When customer deposits are the exception rather than the
riskiest or untested clients—prepay for their goods or
rule, it is then unusual for customer deposits to represent
a significant portion of total footings. A small customer
As with customer deposits, deferred revenues arise with
deposits account is usually a sign of limited or no predic-
a debit of cash and a credit to deferred revenues. As time
tive ability for this account.
passes and new balance sheets are issued, the insurance
It is more common for deferred revenues to be applied
company would gradually debit the deferred revenue to
consistently over time and uniformly to all customers. As
reduce it and then transfer it with an offsetting credit to
a result, deferred revenues often constitute a substantial
revenues earned, reducing the deferred revenue account
percentage of a company’s total capital. Therefore, when
February 2009 The RMA Journal
present, deferred revenues and their trend can be reliable
thus not realistic to say that use of deferred revenues must
indicators of future revenues in almost all cases.
be limited for the benefit of individual customers the way
Large changes in deferred revenues and customer depos-
deposits should be. Therefore, the balance of this discus-
its should always be investigated. Changes in these accounts
sion will focus primarily on customer deposits.
can reflect changes in policy, but more often reflect either
an increase or a slowdown in business. An increase in cus-
Testing for Permissible Use of Customer Deposits
tomer deposits sometimes reflects the company’s newfound
It is relatively simple to determine whether customer de-
selling power, whereby it now has the power to successfully
posits have been used only for the benefit of the individual
require deposits, which it could not do in the past. Con-
customers or to benefit the business in other ways. As dis-
versely, a decrease in this account might reflect the buying
cussed earlier, it is acceptable for the customer deposit to be
power of the customers, who may have threatened to leave
maintained as cash on hand or as restricted cash. It is also
for competitors if the deposit requirement were not loos-
okay to purchase inventory that will be used for the cus-
ened. If the deposits were relied upon as permanent capital,
tomer’s benefit. And it is also acceptable for the deposit to
then this could leave the business seeking new sources of
be used to pay for labor and other costs related to the job.
capital—and maybe in a hurry, too.
This last point warrants further attention. Accrual-
based financial statements prepared in accordance with
Other Predictive Abilities
GAAP will employ the matching principle. Simply put,
We have discussed how customer deposits and deferred
this theory states that expenses used to generate revenue
liabilities can be used as proxies for a backlog report and
will not be recognized as expenses until the revenue is
as revenue forecasting tools. But these two balance sheet
earned, thereby “matching” the expense with the period
accounts have even greater usefulness to us when we at-
in which the sale is recognized. Within this framework,
tempt to analyze a business’s financial health and the re-
then, any labor or other expense used toward the produc-
spectability of its management.
tion of the swimming pool, say, cannot be expensed until
Let’s begin by asking this question: Once a business
all or a portion of the revenue from the completion of that
has collected customer deposits and/or deferred revenues,
job has been earned and recognized. Until that time, such
what may it do—or not do—with that cash? Up to this
costs must be reflected on the balance sheet as prepaid
point, we have matched these accounts with a debit to
expenses (sometimes referred to as prepaids or deferreds).
cash. In practicality, however, a business may legitimately
Thus, customer deposits used properly might also show
use some of this cash in fulfilling the order. For example,
on the balance sheet as prepaids.
a swimming pool company might use all or a portion of
In practice, many businesses do not go to such great
the customer deposit to order inventory and pay the la-
lengths to accrue prepaid expenses, especially if the fi-
bor used to install the product. Or a law firm might use
nancial reporting is prepared internally. In the absence
its customer deposits (retainer) to make photocopies and
of prepaids on the balance sheet, it will be important to
employ paralegals to research the client’s case.
make some allowances in our test for this fact, such as an
Such use of customer deposits complicates what we can
estimate for prepaids.
expect to see on a set of financial statements. It is reason-
To summarize, we know that cash, inventory, and
able to expect that a deposit collected from a customer
prepaid expenses are all permitted uses for customer
will be used only for the benefit of that customer—that
deposits. While there
is, toward the completion and delivery of the product or
may be cash, inventory, Many businesses do not
service and for nothing else. In reality, businesses can and
and prepaid expenses go to such great lengths
do use such customer deposits for other purposes. But to
not related to customer
use a customer’s deposits for other purposes is to put that
deposits, we can expect to accrue prepaid
customer at risk of not receiving either a finished product
to find customer depos-
expenses, especially if
or service, or a refund of the deposit. While this is always
its invested primarily the financial reporting
a risk in business due to unforeseen circumstances, at least
within these accounts.
deposits used only for that customer’s benefit might be
customer is prepared internally.
recoverable, or the work in process might be transferable
deposits should not ex-
to a new supplier for completion.
ceed the amount in these account items on any given
In the case of deferred revenue, it is very common to make
balance sheet. We can apply a formula to test for permit-
unrelated use of that money right away. Whereas customer
ted use of customer deposits as follows:
deposits are usually allocable to individual customers, and
thus should accrue to their benefit, deferred revenues are
Cash + (Inventory - Accounts payable - Loans related to carry-
effectively commingled for the benefit of all customers. It is
ing inventory) + Prepaid expenses >= Customer deposits
The RMA Journal February 2009
Notice that inventory is being reduced by the amount of
accounts payable and other credit used to carry inventory.
This is done for the simple reason that inventory financed
by others need not also be financed by customer deposits
(and thus the deposits should be found elsewhere on the
balance sheet, most preferably in cash).
A Tale of Two Borrowers
Now let’s look at a side-by-side comparison of two borrow-
ers (Table 1). Customer deposits represent a substantial
portion of total capital for both companies.
Companies A and B are in similar industries. They
both sell products and services to consumers. Reviewing
the permitted use test, we see that Company A has used
deposits for purposes other than those we’ve previously
recognized. Roughly 75% of total customer deposits, or
Balance Sheet (In thousands)
$680,000, has been used by company management to pay
other bills. Said another way, there are roughly $680,000
fewer assets on the balance sheet than there should be
(and, accordingly, also probably impairing net worth).
In stark contrast, Company B holds 111% of custom-
Fixed & Other Assets
er deposits in the form of cash. This suggests that, were
Company B to be liquidated today, all customer deposits
could be returned intact. Furthermore, Company B shows
a $127,000 surplus above the permitted uses of customer
Asset-based Line of Credit
deposits, suggesting strong balance sheet management
and good stewardship of those deposits on the part of
Returning to Company A for a moment, we see that one
thing stands out: the size of the distributions relative to
both net profit and EBDA. At first glance, it seems pecu-
liar that there is a shortfall of customer deposits and that
the owners distributed more cash than earnings. A trend
analysis of the “permitted uses” test would be helpful here
to identify whether the non-permitted uses increased or
decreased. If the increase were approximately $325,000
Permitted Uses Test
(that is, the difference between distributions and EBDA),
then we can reasonably conclude where the money went.
What if management had used the cash to pay for other
- Accounts Payable
business expenses? A primary concern would be for the
- Asset-based Line of Credit
business’s solvency. An insolvent business would be ex-
pected to return deposits to its customers, but if that cash
had been spent on unrelated expenses, it would probably
Total Net Permitted Uses of Customer Deposits
be unable to do so.
- Customer Deposits
If we used our other analytical tools and determined that
Customer Deposits Surplus/(for Non-permitted Uses)
the company is solvent, and if we believed that it would
continue to be solvent in the near future, then our concern
* The asset-based RLOC is used to support both accounts receivable and inventory for Company B. When the
would turn to one of adequate capitalization. With debt-
banker is also the lender on the RLOC, the amount advanced on inventory can easily be separated from the
to-worth of 14:1, Company A seems rather leveraged. We
amount advanced on receivables. In this case, the banker analyzing the balance sheet is not the lender, so a
standard 75% advance rate on receivables is applied to determine usage on receivables. Therefore, 75% of
would then review the distribution of financing for the
$250,000 equals approximately $187,000 and represents the amount of the RLOC outstanding supported
company’s assets. The $1.8 million of inventory is already
by receivables. The balance, $113,000, is the amount estimated to be supported by inventory and thus is the
spoken for, supported by $1.3 million in trade payables,
amount shown above.
$300,000 outstanding on a line of credit, and $200,000 in
February 2009 The RMA Journal
As proxies of backlog and as revenue forecasters,
customer deposits and deferred revenues are
pretty reliable given a few parameters.
equity. All that’s left is $900,000 in customer deposits and
• Debit to pay other expenses of the business. This can be a
$300,000 in other liabilities to support $20,000 in cash
sign that cash flow is insufficient to pay the bills. Fur-
and $1,180,000 in fixed and other assets.
thermore, if this non-permitted use is combined with
From this perspective, Company A is improperly capi-
net losses or otherwise tight cash flow, then there is a
talized. Fixed assets should be supported by equity and
very fair possibility that the company will encounter in-
long-term debt, not by customer deposits. However, since
solvency absent new sources of capital.
the company is already highly leveraged, the option of
long-term debt as a source of financing dwindles. It seems
clear that, over time, customer deposits have been used as
The “permitted uses” test for customer deposits is an im-
a form of long-term financing, probably because of their
perfect tool. It inherently assumes that all cash, inven-
relative stability. The shortage of equity could, in fact, be
tory, and prepaids relate only to the orders connected to
caused by the distribution of customer deposits to share-
customer deposits. This will usually not be the case, and
holders over time, thereby bolstering our prior conclu-
thus it is possible to achieve a false-positive reading: a case
sions regarding possible uses of that cash. All signs point
where cash, net inventory, and prepaids are sufficient to
to the need for additional cash equity in this business.
meet customer deposits on the balance sheet, but none of
the cash, inventory, or prepaids relate directly to the jobs
Non-permitted Uses of Customer Deposits
of the customers who have submitted deposits.
If customer deposits are used for purposes other than
This article promised a way to tell a company’s future
those we expect, our test from above would result in a
by using a couple of items on the balance sheet. As proxies
negative number. Since we know that customer depos-
of backlog and as revenue forecasters, customer depos-
its sit on the balance sheet as a credit, we must then ask
its and deferred revenues are pretty reliable given a few
ourselves what kinds of accounts might take debits and
parameters. When combined with the test for permitted
thus the offsetting record in the journal entry. Let’s explore
uses, customer deposits can also tell us if a business is
adequately capitalized, thereby alerting us to possible bal-
• Debit to purchase other assets. Customer deposits should
ance sheet changes in the future. They can also reveal a
not be used to purchase fixed or other assets, but to use
much more nebulous truth: how the principals manage
deferred revenues for this purpose is not a big issue.
the company’s financials. v
For example, a fitness club needs to ensure that it has
satisfactory equipment for its members’ use, so it is with
merit to use advance payments to make such fixed asset
John Cassis, CRC, is vice president and senior risk officer, Wachovia Bank, Fort
Lauderdale, Florida. He also is a member of the Editorial Advisory Board of The RMA
• Debit to reduce accounts payable or revolving credit lines.
Journal. Contact him by e-mail at firstname.lastname@example.org. The views contained in
Customer deposits should not be used to reduce other
this article are solely those of the author and not necessarily those of Wachovia Bank,
debt. It can be a sign that sales are being collected too
its affiliates, or subsidiaries.
slowly to pay off this debt. That said, since both trade
payables and credit lines are netted out in the “permit-
Letters to the Editor
ted uses” test above, this is one of the lesser evils.
• Debit to reduce related party debt, pay distributions to own-
To share your comments about this article with readers,
ers, or increase notes receivable from related parties. If this
send a letter to the Journal at email@example.com.
is occurring, the banker will want to discuss the matter
with the borrower’s management. There is also the risk
that the company will become undercapitalized, as dis-
tributions would reduce net worth.
The RMA Journal February 2009