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  • Revenue Recognition – Measuring Financial Success

    Posted by Lisa Bilski, Director of Finance

    Revenue Recognition – Measuring Financial Success

    Our firm measures financial success on multiple levels. Our project managers track success in terms of profitability on their projects. Our market directors track our success in terms of profitability in their markets, and the executive team and our shareholders track our success in terms of profitability for the firm as a whole. 

    Profit is calculated as the revenue at any one of these levels (project, market or firm wide) less any expenses during the same time period. Knowing this, it is important to us to understand how we determine our revenue.

    In accounting terms, revenue is recognized in different ways depending upon the method used: 

    • Cash-basis accounting is the simplest form, and includes recognizing revenue when cash is received and recognizing expenses when cash is spent. This method is how most of us manage our personal finances and works well in that context. For a business, however, it makes more sense to use the accrual-basis accounting method, in which revenue is recognized when it is earned and expenses are recognized when they are incurred. Accrual-basis accounting conforms with Generally Accepted Accounting Principles (GAAP) and is the method we use.

    Even firms who use accrual-basis accounting sometimes recognize revenue differently. Smaller firms often recognize revenue when an invoice is sent, which is an improvement over the cash-basis method but is still flawed. 

    For example, if a firm is allowed by contract to bill only on milestones, and each milestone takes three months, the revenue and profit of the firm will fluctuate wildly month to month.

    In the first two months, the firm would show no revenue for the project, but would show the expenses associated with achieving progress, making it seem that the firm was operating at a loss.

    In the third month, the firm would show all of the billing for the milestone as revenue, but show only the expenses associated with completion during the month, resulting in a hugely profitable month. Below is an example of a three-month income statement using this methodology:

    Scenario 1       

    Month 1 (20% progress)

    • Revenue: 0
    • Less expenses: 27,000
    • Profit: - 27,000

    Month 2 (35% more)    

    • Revenue: 0
    • Less expenses: 47,000
    • Profit: - 47,000

    Month 3 (100% complete)

    • Revenue: 150,000
    • Less expenses: 61,000
    • Profit: 89,000

    Investors and lenders alike would be very concerned at the cumulative losses of $74,000 shown in the second month under this scenario!

    We recognize revenue according to the percentage a project is complete. Consider the above scenario, with a contractual requirement to bill only on milestones and a period of performance for each milestone of three months.

    We perform services throughout a project that earn value, even if we cannot bill for them. This does not mean that we recognize revenue evenly over the time period, as it is unlikely that services are performed perfectly evenly. 

    Additionally, we do not recognize revenue based on how much we have spent, as we may be more or less efficient in a give time period.  Determination of progress should be made based on what has been accomplished.  Below is an example of a three-month income statement using this more appropriate method:

    Scenario 2         

    Month 1 (20% progress)

    • Revenue: 30,000
    • Less expenses: 27,000
    • Profit: 3,000

    Month 2 (35% more)    

    • Revenue: 52,500
    • Less expenses: 47,000
    • Profit: 5,500

    Month 3 (100% complete)

    • Revenue: 67,500
    • Less expenses: 61,000
    • Profit: 6,500

    This scenario gives both our internal and external stakeholders a much more accurate picture of our financial success at any given point in time.

    Therefore, the next time a project manager comes to you and asks how much progress you have made toward a milestone, please be as accurate as possible. Sharing incorrect information can lead to an inaccurate picture of financial success.

    Image courtesy of SOMMAI / FreeDigitalPhotos.net

    Category: Business, Finance