Steve Davies Online

As you know, I believe that it is essential to match the revenue and the costs associated with delivering that revenue in the same time period.  I am continually astounded when I see people booking contract revenues when they receive the cash irrespective of the period to which that payment relates. This is a fundamental mistake that can potentially deliver spectacularly misleading information.  

Fundamental Revenue Recognition Errors     

In my computer service company, most of my service contracts paid quarterly. For some reason that I could never fathom, the quarters beginning January, April, July and October were the highest billing, the quarters beginning March, June, September and December were lower by about 20%  and the quarters beginning February, May, August and November lower by about 40%.  

That meant that based on 30 day collection terms (I wish!) my quarterly invoicing and cash receipts looked like this:  

If I booked revenue based on invoicing, then the first month of each quarter (January April, August, and October) would be strong, the second month of each quarter (February etc) would be moderate and the third month of each quarter (March etc) would be weak. 

If I booked revenue based on collections (assuming net 30 terms adhered to) then I would show a very different picture. The first month of each quarter (January April, August, and October) would be weak, the second month of each quarter (February etc) would be strong and the third month of each quarter (March etc) would be moderate. If I collected in 60 days, however, then I would shift to a different picture again, and this just demonstrates the futility of this approach.  

About a quarter of my customers paid annually, with a big spike at the end of the year. If I recognized these contracts either when I billed them or when I collected them, then the picture would have been skewed even more, with wild revenue swings that simply did not reflect the true underlying activity or profitability.   

Revenues are the start point against which other information can be measured. Recording contract revenues when they are billed or when they are collected produces false margins and renders the revenue line useless for analysis purposes. It simply does not give you the information you need to run your business effectively. Your numbers have become the master and you are blindfolded, with no idea where you really are.   

If revenues are recorded based on billing or collections and expenses are recognized when they are paid, then the direct profit picture swings wildly and does not in any way reflect what is really going on. The resultant picture is not only useless and misleading, but it can be downright unhealthy. In the first place, it provides almost no useful information. More damaging is the impact that poor information can have on your decision–making process. Suppose your direct profit on contract revenues after all variable expenses connected with delivering the service was a respectable 40%. That would mean that your variable servicing expenses averaged 60% of your contract revenues of $1.2m or $720,000. Unfortunately, those costs have to be paid each month and I haven’t yet found a way to get service technicians to agree to be paid in line with how I choose to recognize revenue.      

If I produce my monthly financial statement based on these numbers (which assumes a level of organization in excess of what most people have) they tell me nothing….except that perhaps I should be starting to have a mild panic when I see the results from March and June:        

Revenue Recognition that makes sense 

Instead of recording revenues based on invoicing or collections, the revenues should be based upon when they are earned. In the accounting world this typically drives from when the service is performed. In the contract revenue world, the best way to record revenues is simply to take the amount of the contract and divide it by the number of months that it is in effect.  

Based on this approach, I would record my revenue very differently, and there are two concepts that need to be understood before moving forward to the next stage:  

1.     Annual Maintenance in Force (AMIF)    

This is the annualized total of all the service contracts you have at any given point in time. If nothing more sophisticated exists, use Excel to create a report of every contract, start date, end date, number of months and total contract amount. Track it monthly so that you can produce a total of AMIF each month.  

2.     Recognized Monthly Income (RMI)     

Recognized Monthly Income is the device used to “smooth” out the variations in revenue described above. It is calculated by taking the total contract amount and dividing it by the number of months covered by the contract. The resulting amount is what you will now use to recognize your monthly revenues.  

For instance: If a company has a contract for 12 months for a total fee of $12,000 then the revenue that should be recognized each month is $1,000. If the contract is for two years at a total fee of $18,000 then the revenue that should be recognized each month is $750…..  

To record contract revenues in this way you need to build a new model. For simple businesses this can be done in Excel. For more complicated businesses you may want to build a program that manages your contract information and drops it in automatically.  

Start by calculating AMIF each month. The simplest way to do this is on the “perpetual inventory” basis. To do it this way, you add up all contracts at the start of the year, track additions, changes and cancellations each month and recheck the figure periodically (at least annually).   

I always like to track AMIF into RMI each month. The picture changes a little when you do that, and as the AMIF changes, so does the RMI. It is important to measure that and reflect the change every month or else you don’t track revenue properly and build up an adjustment that must be made at year end (positive if you are growing, negative if you aren’t) that skews the numbers. 

On the AMIF spreadsheet, add one extra column for RMI, and calculate the monthly amount by dividing AMIF by 12 to arrive at the monthly amount to be recognized.  

Compare that with Table Three - Erratic Revenue Recognition with Cost Overlay and you will quickly see how the revenue recognition is different depending on which methodology you use. In that presentation, March and June looked like bad months; now the wild swings have been eliminated and a much more meaningful picture emerges.   

The costs are too smooth and linear (unlike in real life) but it does drive home the lesson:  If you measure results based on revenues that don’t match your costs then you have simply developed measurement criteria (assuming you actually measure anything) based on a fallacy. All you have done is to “capture Greenland” – an exercise in futility.          

Deferred Service Liability  

Deferred Service Liability occurs in those cases where payment is made in advance for services to be performed under a contract at some future time. You have been paid and yet you still have the contractual obligation to provide service under the contract, and this should be recorded on the Balance Sheet as a liability.   

It exists whether or not you record it….it is just a question of whether you choose to recognize it in your financial statements. If you use invoicing to record revenues, then the other side of the ledger is simply receivables; if you use collections, then the other entry is cash, and nothing in either of these ways of recording revenues forces you to record any Deferred Service Liability.   

From a day-to-day management perspective, it all comes down to having real information to make decisions. If you want to get an accurate picture of the value of your revenue stream then DSL really needs to be calculated and recorded on the Balance Sheet. It is important from the perspective of understanding your business, and if you ever plan to sell, the buyer will certainly address it…and deduct it from the purchase price.  

In the case of product-related revenues, the cash received would be treated as a deposit. In the case of contract revenues it is recorded, if you decide to book it, as deferred service liability on the Balance Sheet, reflecting your contractual obligation to provide future services. If you adopt the RMI methodology then it will force you to recognize DSL.  

If you had a quarterly contract for $12,000 a year that paid quarterly, your RMI and DSL would look like this:  

Under the RMI method, DSL will automatically come into play and it needs to be calculated on a monthly basis. To record it you will need to set up a Deferred Service Liability account on the Balance Sheet, and then it is a two step process.  

Having set up the Deferred Service Liability account, the contra entry to record the invoice raised will be the DSL account rather than revenues. The second entry will be to reduce DSL each month for the amount of the monthly RMI. The bookkeeping entries are shown in the Appendix to this section.  

From a Financial Statement perspective, this may look complicated, but I practice it is quite simple. To record contract revenues using the RM|I method, the report is going to record AMIF and RMI. If invoicing is added to the report then it is a simple matter to bring the Deferred Service Liability into the reporting paradigm.  

An opening Deferred Service Liability number needs to be calculated at the beginning of the first reporting period. Then monthly DSL can be calculated each month on a management report through the following calculation - Last month DSL plus invoicing minus RMI recognized this month equals closing DSL.  

This calculation can be neatly added to the AMIF and RMI report:      

In a simple business this can be recorded on an Excel spreadsheet and the mechanics are really quite straightforward. In larger or more complex businesses, it makes sense to build a custom program that interfaces with the billing system. That’s what I did in my computer service business.  

I had over 2,000 contracts with AMIF of $16.5m and I built a custom program to record contract information, annual amount and renewal details. It created my monthly AMIF number and I was able import my billing. From there I was able to create an accurate RMI number and DSL was calculated as the difference between invoicing and revenue recognition.  

The result was much as I have laid out above except that I found the need to have an extra column to record adjustments such as retroactive changes in contract amount that I wanted to impact through current period RMI.               

APPENDIX – Contract Revenues  The bookkeeping entries to record revenue under the three different methodologies are as follows.  I obviously strongly recommend that you use the RMI method.  

That’s the beauty of accounting….but remember that you are using these numbers to give you (and only you) information. What you do with it subsequently is supremely unimportant. This is for you - what you need to know to run your business better.