Project Deposits vs Retainers: Accounting Rules for Professional Services Firms

Project Deposits vs Retainers: Accounting Differences

Receiving a large client deposit feels like a win. The cash is in the bank, signaling commitment and easing immediate cash flow pressures. However, a common mistake for early-stage professional services firms is booking that cash as revenue the moment it arrives. This decision, while tempting, creates significant downstream problems. Understanding how to record client deposits and retainers in accounting is not just a bookkeeping task; it’s a foundational step for building a stable, predictable business with accurate financial reporting.

The Foundational Rule: Why Prepayments Are Liabilities

The core of handling prepayments correctly lies in the Revenue Recognition Principle. This accounting rule states that revenue should only be recognized when it is earned, regardless of when the cash is received. For US companies, this principle is formally defined in US GAAP's ASC 606 ('Revenue from Contracts with Customers'). In the UK, the equivalent standard is FRS 102. The purpose of this principle is to ensure your financial statements provide a true and fair view of your company's performance in a given period.

So, what is that cash you just received? It’s a liability. You owe your client future work or services. To track this obligation, your bookkeeping system needs a specific account on your balance sheet. This account is typically called “Deferred Revenue” or “Unearned Revenue.” It sits there as a debt you owe your client until you perform the work, at which point you can finally move it to your income statement as earned revenue.

Applying the Rule: How to Record Client Deposits and Retainers

Here’s where it gets simple: for accounting purposes, most project deposits and service retainers are treated identically. Whether it’s a 50% upfront payment for a six-month web development project or a monthly retainer for ongoing public relations services, the process is the same. They are both client prepayments for work you have not yet completed and require the same approach for proper unearned revenue accounting.

A scenario we repeatedly see is a design agency that requires a $10,000 deposit on a $20,000 branding project. When the cash arrives, the correct journal entry is:

• Debit: Cash ($10,000)
• Credit: Deferred Revenue ($10,000)

Notice that no revenue has been recorded. The agency's cash balance on the balance sheet increases, and so does its liability. Let’s say the agency completes half the work by the end of the month, justifying earning half the deposit. They would then make an adjusting journal entry to recognize the revenue:

• Debit: Deferred Revenue ($5,000)
• Credit: Service Revenue ($5,000)

Now, $5,000 has moved from the balance sheet (reducing the liability) to the income statement (increasing revenue). The remaining $5,000 in Deferred Revenue stays as a liability until the rest of the project is delivered. This systematic approach to advance payments handling provides a true picture of your firm's monthly performance.

The Exception That Proves the Rule: The 'True Retainer'

Founders often ask if any retainers can be booked as revenue immediately. The answer is yes, but only in a very specific and rare circumstance known as a “true retainer.” Unlike a standard service retainer, which is an advance payment for future work, a true retainer is a fee paid purely to guarantee your availability. The client is paying for access to you and your firm, whether they use your services or not.

In this specific case, the fee is earned upon receipt because the service being provided, availability, has been delivered for that period. However, this cannot be a casual assumption. This arrangement must be explicitly and clearly defined in your client agreement, with precise legal language distinguishing it from a prepayment for services. For nearly all professional services firms, retainers are for work to be performed and must be treated as a liability until earned.

The Downstream Impact: How Clean Books Accelerate Growth

Why does this accounting detail matter so much? The practical consequence tends to be significant, impacting taxes, fundraising, and internal forecasting. Incorrectly handling service contract deposits can create operational and financial hurdles that inhibit your company's growth.

Impact on Tax Planning

Recognizing client deposits as revenue too early artificially inflates your sales figures and profit on your income statement. This can trigger avoidable tax liabilities on cash that hasn't truly been earned. You could end up paying tax on money that you might have to return if a project is cancelled, putting unnecessary strain on your finances.

Impact on Fundraising and Due Diligence

Failing to record retainers in a separate deferred-revenue liability account creates messy books. During an audit or investor due diligence, this misrepresentation of revenue must be unwound, causing costly delays and eroding trust. Investors want to see predictable, properly recognized revenue streams, not lumpy cash receipts disguised as sales. Accurate retainer agreement bookkeeping is a sign of a well-run, disciplined company.

Impact on Cash Flow Forecasting

Most critically, misclassifying deposits skews your cash-flow forecasts. Research from the NSBA 2022 Economic Report shows that cash flow was the biggest financial issue for 21% of small businesses in 2022. When you assume a deposit is available cash, you risk being short when the actual project costs, like contractor payments or software licenses, come due. Treating it as a liability enforces the discipline to hold that cash until the work is done.

Putting It to Work: Your 15-Minute QuickBooks Setup

Implementing proper advance payments handling in your accounting software is straightforward. The reality for most startups at this stage is more pragmatic, and this setup can be done by a founder or bookkeeper in minutes. The process is similar in popular platforms like QuickBooks and Xero.

1. Create a New Account: In your Chart of Accounts, add a new account. For the account type, you must select "Other Current Liability." This ensures it appears on the correct part of your balance sheet.
2. Name It Clearly: Name the account "Deferred Revenue" or "Client Prepayments." Consistency is key, so choose one name and stick with it.
3. Adjust Your Workflow: When you receive a deposit, apply the payment directly to this new Deferred Revenue liability account. Do not apply it to a sales or income account.
4. Recognize Revenue Monthly: At the end of each month, create a journal entry to move the portion of revenue you earned from the Deferred Revenue account to your Service Revenue account. This is the step that turns the liability into recognized income.

This simple, four-step process ensures your financial statements are accurate from day one, reflecting one of the most important professional services billing practices.

Key Principles for Handling Client Prepayments

Mastering how you record client deposits and retainers in accounting boils down to a few key principles. First, cash in the bank is not the same as revenue earned. Any payment received for work not yet completed is a liability, representing a promise you must fulfill to your client. Always use a dedicated “Deferred Revenue” liability account to hold these funds on your balance sheet until the work is delivered.

Get into a monthly rhythm of making a journal entry to move the earned portion from your liability account to your income account. This discipline ensures your financial reporting is accurate and your cash flow forecasting is realistic. Unless your legal counsel has confirmed your contract qualifies as a rare “true retainer,” always treat advance payments as liabilities. This clean accounting practice is essential for financial stability and future growth.

Frequently Asked Questions

Q: What is the difference between deferred revenue and accounts receivable?

A: Deferred revenue is a liability representing cash received for work you have not yet done. Accounts receivable is an asset representing revenue you have earned but for which you have not yet received cash. One is an obligation to perform services; the other is a right to collect money.

Q: What happens if a client cancels and I have to refund a deposit?

A: If you refund a deposit held as deferred revenue, you would debit the Deferred Revenue account to reduce the liability and credit your Cash account to reflect the payment. This correctly removes the obligation and the cash from your books without incorrectly impacting your earned revenue figures.

Q: Can I use cash-basis accounting to simplify how I record client deposits and retainers?

A: While cash-basis accounting is simpler, it can provide a misleading view of your company's monthly performance and financial health. Accrual accounting, which uses the deferred revenue method, is required by US GAAP and FRS 102 and is essential for businesses seeking investment or a true picture of their stability.