If you’re starting a service business, you may have concluded that it makes sense for you to charge a retainer up-front. When dealing with small business or individuals, charging a retainer can help you make sure you don’t get stuck with invoices you have trouble getting paid. Maybe your clients ran out of cash unexpectedly or maybe they decided the agreed upon work wasn’t actually what they wanted and refused to pay. In any case, work you perform has a cost associated with it so covering yourself to prevent losing money on deals is a top priority. If you can’t collect more cash than you spend, your business will face certain death, no matter how popular your offering.
What people often overlook is how to account for retainers. Client retainers are generally not considered earned which means you should plan on applying retainer to the client’s final invoice or you should plan on returning the retainer at some point in the future. In short, a retainer is a liability that must either be repaid or earned. Many new business owners don’t understand that retainers should be recorded as a liability. Failing to do so, can lead to losing track of funds and businesses spending the retainer and not having it if a situation arises where the retainer needs to be returned to the customer.
The problem of how to keep books for client retainers highlights a bigger need to understand two methods of accounting – cash basis and accrual basis. Cash basis means you don’t recognize income or expenses until cash is received or paid, respectively. Accrual basis means you recognize income when earned and expenses when incurred.
In the case of many small businesses, tax preparation is often performed on cash basis. In other words – from a tax perspective – there’s a good chance you must pay taxes on the client retainer when you receive payment.
When you operate a business where you exchange product for payment similar to what you would think of in a local market place, this distinction doesn’t matter because cash is received when the income is earned.
In the service world, there is a bit more variation in treatment. Perhaps if you’re a handyman, you require payment the same day, in which case cash basis = accrual basis revenue. Or maybe you have some customers that you send an invoice and they pay you (hopefully) in the next 15 days or so. The latter example represents a scenario where cash basis income < accrual basis income at the time when service is provided.
If you read this far then hopefully you conceptually understand what you need to do to correctly account for client retainers. Executing it requires a bit more detailed understanding of whatever software you use to do your bookkeeping. If you have any doubts at all, it’s probably in your best address to have a bookkeeper or accountant who understands your software and any conditions related to your client retainer agreement to set it up for you.