Dumb accounting question. Revenue recognition
 

I have a really dumb question.

In a business, when does a company recognize revenue for services rendered? When they bill the company as accounts receivable or when they receive the cash?

I just wanted to figure out how a large bill sent out by our company right before the end of a quarter would be recognized by our company.

Thanks.

In general terms, you would use accrual basis under which revenues and expenses are recognized when both of the following conditions are met:
-Revenue is earned (products are delivered or services are provided)
-Revenue is realized or realizable (realized=cash is received/realizable=cash will be received)

However if you use cash basis accounting, Revenue is recognized when cash is received.

Hope that helps !

Interesting question, some companies report sales in terms of orders taken while others report slaes in terms of bills paid. I like the latter only because sales reps can be not so much honest...

Having had a publicly traded client just pulled through the keyhole by accountants on this very issue, I can offer the following... but don't extrapolate too far. this assumes a normal "purchase order" based relationship, in the absence of a controlling supply agreement, and more importantly (and theoretically) no conflict between standard terms of buyer and seller.

Essentially, on an accrual basis in the absence of an agreement to the contrary, an account receivable becomes a sale (for goods) contemporaneously with transfer of title and risk of loss.

Under an EXW delivery term, for example, title and risk of loss transfer when goods are made available to a carrier at the seller's facility. So, when the stuff is on your dock, waiting for UPS/FedEx/whatever, you have "delivered" and title and risk of loss are now the buyer's. You invoice at that time, under whatever your payment terms are, and you've made a sale as of that delivery date.

Things get more complicated with title transfers while in transit (under bills of lading and letters of credit) but essentially come down to, when are you entitled to claim payment.

If you are delivering DDP (delivered duty paid) DAF (delivered at frontier) or some place other than at your dock, or at the carrier, you need to track when the goods arrive at the stipulated point, because that is when title and risk of loss transfer, at which point you will have "delivered" and have a sale. This can be a logistical hassle, obviously.

ATEOTD, if you're not a reporting company, you can have systems that vary from this paradigm, as long as you apply that system consistently. If you have "minimum" or "take-or-pay" contracts, for example, your accounting will need to be addressed accordingly.

JP

A lot of publicly traded companies use receivables to "pump up" their earnings just before the quarter ends.

It has been (and still is) an "aggressive accounting" technique used by a number of companies with high flying stocks. "Make the sale and book the revenue" is the behavior -- with little to no regard for the "delivery" of the product/service after the sale, or the ability of the purchaser to pay for what he just agreed to buy!

The end result is "write-downs" in some later quarter when payment doesn't materialize (often after the insiders have sold their shares!)

Big receivables, heavy insider selling = bad investment.

All good points but he's asking about services RENDERED.

Thanks, that helps a lot.

Unfortunately, in my case, our company is using revenue recognition tricks to kind of screw me out of a commission. Our little business unit was supposed to get an extra commission on accounts that were paid prior to X date. So we invoiced our client for those accounts that paid prior to X date. Now our company is saying they are using cash basis accounting and we aren't due those commissions because the invoices weren't paid prior to X date. Bastards. Unfortunately, nothing is in writing...

I don't think it will really matter that services have been rendered -- other than to say that it is more likely that the "bill" will be booked as revenue.

If the services were provided to a solid credit risk, the receivable will be "as good as money in the bank."

If there is any question about the abilities of the company receiving the bill to actually pay that bill (in a timely manner or at all), the accountants might not book all of it as revenue.

The "aggressive accounting" I've seen involves booking any and all sales as revenue with little to no regard to the "credit risk" of the buyers, and carrying a heavy receivables number on the balance sheet -- which eventually needs to be written down when a large number of the bills outstanding end up not being paid.

I understand Competentone, there should be a provision for uncollectibles (in laymen's terms :) ). I guess next time I will have to write the long version of the answer, oops wait a minute, that one carries fees ;)

Neil, you do say that your commision is on a cash basis ("on accounts that were paid prior to..").

Hope it works out for you.

If they are really using cash basis accounting, that should be a matter of record. If they are saying they are using cash basis accounting just in your unit, just for figuring the agreed upon commissions, but are not doing the same when they book the revenue you helped generate for the company as a whole, then yes, in my ("non-accountant") understanding of things, they're "screwing you" out of a commission.

It sounds highly unethical; maybe illegal too.

For a services business using accrual accounting, revenue is recognized when the service is delivered and accepted by the client according to the delivery/acceptance terms on the contract. You can find scads of language that provides for the on-going recognition of revenue for long-term contracts as key milestones are accomplished. Just search the 10K's for any large services company.

Any company/management that attempts to shortchange commissions/bonus/incentive comp by playing with accounting periods, collections, etc. is very short-sighted. The implication is that reward systems are not aligned between the business units and various managers which encourages gaming the system. For example, if your business unit was incented to maximize billing but the divisional head was incented to cut cash compensation, your scenario results.

and the way I read it, that's what he seems to be saying. Commisions are on a cash/collected basis but books are on accrual (I guess taxes are on cash as well).

I don't see why it would be unethical though? They are paying a commision on moneys actually received. As such, and as long as they do pay the commission, I don't think he's getting screwed.

I've actually seen a lot of the contrary where consultants overbill the client, get their commision on accrual basis and then the companies have to give credits to the clients and end up out of pocket.

BTW, I'm not saying that's the case here just trying to understand why the commisions are paid on a cash collected basis.

I'm assuming (perhaps incorrectly) that if the "sale" was not made before "X" date, then the "extra commission" would not be earned.

The unethical part: If his unit was familiar with the company's accounting and were operating with the expectation that the extra commission would be paid based upon accounting they were familiar with, but then the company says, after the work is done and the extra commission is expected, "Oh, in this case we're using cash accounting, so you guys actually missed the deadline for the extra commission because we haven't received payment yet from your sale. Sorry."

Actually, maybe I'm not understanding this. Particularly the "unit was supposed to get an extra commission on accounts that were paid prior to X date."

That would be commissions on a cash accounting basis, wouldn't it?

(I have to get back to work -- I'll check back later.)

I get your point but I read Neil's description differently.

Apparently they did say that commisions were payable when collected (paid prior to X date) however they were not paid prior to X date. If they are not lying about collections I can't see the problem.

Cool exchange of ideas, thanks !

Yeah, I must get to my regular accounting job now....

Do a google search on 'financial restatement' , maybe include Nortel and you'll realize there ain't anything dumb about your question.

I'll explain what happened tonight... but I do feel like I've gotten the raw end of the deal.

It is quite common for companies to have one type of accounting system for tax purposes and a completely different standard for paying commissions.

Most sales based jobs pay commissions on the sale once the bill is paid. The amount of commission can also decrease if the bill is not paid on time. Many companies make the salesman pay for the 'credit' extended to his customers. This makes the salesman actively involved in the business and forces the staff to find 'better' customers - not just 'customers'.

I've spent most of my career running large sales forces or running stand alone companies. There are as many commission/bonus structures as there are sales managers and creativity.

For stable commercial companies, the sales people are not involved in granting credit terms. So most sales comp plans pay on order shipment (title transfer) when revenue is recognized. Never on orders. And we don't pay when the customer pays however, there is always a reversal clause. Randy's point is relevant - but I wouldn't put it into the "most companies" category at all.

Up to the original post - assuming the company in question recognizes the revenue upon invoicing, unless the comp plan was specifically tied to receipt of funds (A/R) then he got screwed. Or the terms were not well defined, in which case any good comp plan always has the "company makes the final decision" clause.