What are customer advances?
Customer advances can be defined as the amount that is taken from the customers in advance of the order actually being processed. In other words, customer advances are the payments that have been received from the customers in advance. Corresponding order fulfillment for that particular order has not been accounted for. Therefore, this amount has been received prior to the sale actually being completed.
A performance obligation is referred to the task that needs to be completed by an organization in order to complete a certain sale. Without performance obligations being met, customers will not accept the order, and hence, the sale would be nullified. Customer advances normally do not have any performance obligations fulfilled. They are simply advances that are made by the purchaser to the seller before the seller begins working on performance obligation fulfillment.
Despite the fact that customer advances are advance revenues, they are not recorded as revenues because customer advances do not comply with the principle of revenue recognition.
Reasons for Customer Advances
A customer might pay in advance for goods that they plan on purchasing. There can be a number of reasons for customer advances. They are as follows:
- Poor Credit History: In case the client has a poor credit history, organizations might choose to work only with advance.
- Custom products: With highly customized products, organizations normally take customer advances because they intend on preparing the inventory for the particular customer only.
- Cash basis: Some organizations that follow cash basis of accounting might opt to pay cash as soon as possible, so that they can report it as an expense, and subsequently lower their taxable income for the current year.
- Reserved Capacity: Some clients also pay advances to the seller in order to book a certain volume, or ensure that the output would not be purchased by a competitor.
Revenue Recognition Principle and Customer Advances
In accordance with the revenue recognition principle, revenues are supposed to be recorded on the Income Statement for the period when they are realized and earned. This means that revenue can only be recorded if the organization has fulfilled what is required for the transaction to be classified as a sale. Revenue Recognition Principle has 5 main criteria that need to be fulfilled:
- Identification of a relevant contract with the customer
- Identification of performance obligations
- Determination of the transaction price
- Allocation of the transaction price to the performance obligations in the contract
- Recognition of revenue once performance obligation has been satisfied
For example, a furniture shop will record a sale only when they have prepared the furniture, and it is ready for delivery. They cannot record revenues when they receive purchase orders or intent of purchase from the customer. They can only record the revenue when it is ‘earned’ and ‘realized’. This implies they can only record it once they have completed what needs to be done in order to fulfill the order. Therefore, from the perspective of the furniture shop, performance obligation can be defined as the act of preparing the furniture.
By this premise, customer advances do not fall under revenue. This is because customer advances are simply advance payments that are made by customers, and the organization is yet to complete and deliver the order. Therefore, customer advances cannot be classified as revenues, simply because they do not fulfill the revenue recognition criteria. In simple terms, performance obligations have not been fulfilled, because of which customer advances cannot be recorded as revenue.
Classification of Customer Advances
Regardless of the fact that customer advances are amounts received for the purpose of sale, yet they are not recorded as ‘earned revenues’ in the Income Statement. Revenue can be broadly categorized into two forms:
- Earned Revenues: Earned Revenues are revenues that have fulfilled all criteria of revenue recognition principle, and hence, they can be declared as sales revenues. Earned revenues, by definition are revenues that are realized, as well as fulfilled by the customers. Therefore, it makes sense to include them as revenues on the financial statements.
- Unearned Revenues: Unearned Revenues are customer advances that have been received from customers, but there has been no performance obligation as yet. Therefore, they are not classified with Earned Revenues in the financial statements.
Therefore, customer advances are classified as unearned revenues, in the financial statements. Since it is an amount that is not backed by any asset, it is classified as a Current Liability in the Balance Sheet.
The reason behind customer advances being classified as a Current Liability is that this amount is owed by the organization, and they need to carry out performance obligation tasks in order to fulfill that particular sale.
However, it must also be noted that customer advances are only classified as short-term (Current) liabilities if there is a certainty that the order will be processed in a time frame of under one year. If the time frame of completing performance obligations is more than 1 year, customer advances, in that case, are going to be classified as long-term liabilities.
Journal Entries to record Customer Advances
The process from customer advance, to revenue recognition, comprises two broad steps. They include recording changes in the bank and the creation of current liability, followed by abolishing the liability and realizing it as revenue in the financial statements.
When an organization first receives advances from customers, the following journal entry is made:
|Unearned Revenue (Customer Advances)
This is the amount that is received by the organization in return for sale orders they plan on processing and fulfilling in the forthcoming time. Therefore, it is recorded as a Current Liability in the Balance Sheet.
Once the order has been fulfilled (i.e. all criteria of revenue recognition has been met), the following journal entries are created:
|Unearned Revenue (Customer Advances)
The journal entry above shows the transfer from a liability account to a revenue account. This is only done after performance obligations have been settled, and the company can record it as revenue under the Revenue Recognition Principle.
Example of Accounting Treatment for Customer Advances
The concept and accounting treatment for customer advances is further elaborated in the following illustration:
Gogo Inc. is an artisanal furniture shop, which only produces customized orders. Therefore, they take 100% advance from customers, after which they take around 3 months to process the order, and then deliver it.
For the year ended 31st December 2019, they received customer advances worth $40,000 from one customer, in the month of November. This is going to be recognized as revenue in the month of Feb 2020.
In the example above, it can be seen that the customer advance that Gogo Inc. received in November is to be classified as an unearned revenue (a current liability). In order to record this particular transaction, the following journal entry will be made:
|Customer Advances (Unearned Revenue)
Subsequently, in the month of February, when this order is going to be fulfilled, the following journal entry will be made:
|Customer Advances (Unearned Revenue)
The journal entry above shows that the revenue has been earned, and realized. In other words, it fulfills all the criteria of the revenue recognition principle to be regarded as revenue on the Income Statement.