Imagine you are in your board room, you’re a startup. You’ve received your initial funding. You’ve got a great idea for a new, break-through, and innovative product. You’ve built a prototype and done an I nitial consumer test. The results are great and now you’re ready to continue building your product to make it ready for market. You are so excited, but all of a sudden your palms start to sweat. Your investors start asking questions about your financial results. “Oh no! What now?” Then they ask the dreaded question, “When will you turn a profit?”. You think, “I’ve just started my company. I haven’t launched my product yet. How can I be profitable when my product’s still in beta testing, my customer base is small, and I have very little revenue?” Then you think “Well, there must be some way we can show a profit”.
This is what I call the danger zone. This is where we may be tempted to create new ways to define standard accounting and business terms. Let’s step back for a moment. What does “profit” really mean? Merriam-Webster defines profit simply as “money that is made in a business, through investing, etc., after all the costs and expenses are paid: a financial gain”. Simple enough. Right? Well, not really. For some businesses, gross profit (revenue less direct selling expenses) is the key measure of profitability. In other businesses, they may look at the “bottom line” which starts with gross profit, then takes into consideration marketing and operating expenses, income taxes and depreciation expense. Still others may look at EBITDA (earnings before interest, taxes, depreciation and amortization) as a measure of profitability. These are all good measurements, but let’s go back to the definition provided us by Merriam-Webster. Profit, is money, or rather income, earned by a business after all expenses and costs are deducted. When discussing “profits” or “profitability” with your investors it is critically important to not only be consistent in your reporting of profits, but to also be open and honest in your communications. To me, this means reporting revenue and expenses in accordance with generally accepted accounting principles. This will most likely not be a reflection of the actual cash you have in your bank account, but you can bet that if you have a positive “bottom line” your bank account will reflect this.
Stay true to yourself, your employees, and your vision. If you’ve got a product or service that is unique in the market and it’s a product that your customers want, then profit will follow. There is no need to “play” with the calculation of profit. It is best to know what your income is and the expenses you incur to develop and deliver your product and run your business.
Susan Nieland, CPA
When you see headlines like “DOW to Drop 80% in 2016” as a small business, startup or early-stage company you may wonder “will my company survive?” Good question. Here’s where your tried and true forecast comes in prepared with the assistance of your trustworthy CPA.
You may think that your company or organization is too small to worry about developing a financial forecast. Dr. Anandi P. Sahu points out in his post on forecasting that the “long-term success of any organization is closely tied to how well management of the organization is able to foresee its future and to develop appropriate strategies to deal with likely future scenarios.” Many business owners, especially owners of small, startup, and early-stage companies, like to use “gut feel” or the “back of the napkin” forecasting approach. Now, there certainly is nothing wrong with these approaches, but they generally don’t provide you with the flexibility needed to meet changing markets and economic conditions. Which is what you need to effectively run your business and grow. Having the right forecasting tool(s) can go a long way to ensuring your success as a business owner and manager.
Ok, so we’ve got to have a forecast. How do we go about doing this? Good question. As I’m sure you are aware, there are various forecasting methodologies that can be used to create your forecast. For these, I’ll refer you to Dr. Sahu’s post on forecasting which is very informative and explains each of the different forecasting methodologies. What I want to bring to light here is the need to have a solid forecasting model, whether this model is Excel-based, or built in a sophisticated forecasting software. The best way, that I have found in my experience, to have a solid financial forecast is to ensure it has these key attributes:
- It follows generally accepted accounting principles (GAAP) as much as practical. This will allow you to compare your actual results to your forecast easily.
- You capture the attributes of the key drivers of your business whether that be inventory turnover, product sales, customer acquisition costs, recurring monthly revenue, revenue per customer, or another meaningful variable that drives profitability and growth.
- It is flexible; you have the ability to change the values of your key drivers so that you can “see” the effect certain decisions may have on your business.
There you have it, your forecast should follow GAAP, capture your key business drivers and be flexible.
Susan Nieland, CPA
I hear you! You’re sitting there saying “I’m small business; I care more about the balance in my bank account than I do about financial statements, income statements and balance sheets; GAAP. GAAP, whatever that is, is for those “big guys” that have lots of investors, tons of money and have to report to the SEC. It’s just not for me.” I beg to differ though; GAAP, Generally Accepted Accounting Principles, are for you! Read the rest of this entry »
A CPA? What do I need one of those for? What value can they add to my business? They just want me to follow a bunch of accounting rules that make no sense! All valid comments and concerns. If you are a small business, startup or early-stage company, you look at the balance in your checkbook and may have a hard time figuring out what value a CPA could add to your business let alone how you could afford one.
Looking to grow your business? If so, you’ll need capital. Capital that most likely will come from outside investors, venture capitalists (the “VC”). In a recent article, “Meet the man behind the rise of bots and our AI-driven future”, by Caroline Fairchild, the New Economy Editor at LinkedIn, Dennis Mortensen of x.ai, a startup and creator of the Amy Ingram artificial intelligence driven personal assistant, points out that “once you sit in a room [with the investors] and ask for $25 million, it is not about bold ideas; it is about spreadsheets.”
Why are spreadsheets important? It’s my idea, enthusiasm and well defined goals that will make it happen. What value do spreadsheets bring to the equation?
These aren’t just any spreadsheets, they are special spreadsheets, they are forecasts. These spreadsheets tell your story in numbers. Numbers that need to be accurate and realistic so that they are believable. Presenting a forecast that shows not only your projected income and expenses, but your projected assets and liabilities along with projected cash flows, combined with your great idea tells a compelling story to potential investors. Not only that, it shows investors that you are serious and have your act together, have thoroughly thought through your business model and are worthy of their investment. Spreadsheets. Something that most CPAs are not only familiar with, but are adept at creating and deploying. Having the right CPA on your side to ensure that you are presenting complete and accurate forecasts can help ensure that you get the deal done, your company off the ground or sailing to the next level of growth.
CPAs have the skill level and training needed to provide objective, strategic advice, as a result of the rigorous educational training, including ongoing continuing education requirements, combined with years of experience. Held to high ethical standards and a stringent code of conduct, CPAs must meet high levels of competence and professional standards in order to serve individuals and businesses. Trustworthy, hardworking, diligent and objective, all qualities to look for, and expect, in your CPA.
Susan Nieland, CPA
We made it to the final stop! Is it time to actually recognize revenue now? Well, let’s see. What does it actually take to be able to recognize revenue? Satisfy your performance obligation(s). That’s what it takes. “What,” you ask, “does that mean?” Well, let’s look at what it means; let’s break it down.
Back at our second stop, we looked at what our performance obligations were and found that they represented what we’ve agreed to provide our customer in exchange for the contract price or sales price. Our performance obligation(s) could be as simple as handing over a pair of jeans that we’ve agreed to sell to our customer in exchange for their payment or as complex as delivering a software license with an annual maintenance agreement along with installing the software on the customer’s server.
Now, when do we recognize revenue? Our guidance, ASC 606, “Revenue from Contracts with Customers”, tells us that we “recognize revenue when (or as) the performance obligation is satisfied”. “How do we know when we’ve satisfied our performance obligation?”, you ask. When the customer has taken control of the good that we’ve sold or been provided the service we’ve promised, we have satisfied our performance obligation; completed our part of the deal. At this point in time we can recognize revenue.
Let’s take the example we looked at during our fourth stop a step further. In that example, you developed a software product and you license it to companies in the automotive industry. Your new customer is purchasing the software license, annual maintenance agreement, and 100 hours of implementation services for a total contract value of $75,000. Based upon the relative standalone selling price of each of these deliverables we allocated $44,118 of the total contract value to the software license, $22,059 to the installation services and $8,823 to the one-year annual maintenance services. Now the question is, when do we recognize revenue for each of these items? That depends on when each item is delivered to the customer and when the customer takes control of them. Let’s say that you deliver, via secure electronic file transfer, the software license to the customer upon contract signing and payment of 50% of the contract price. The installation services are scheduled to occur immediately after contract signing and will take approximately three weeks to complete. The one-year maintenance agreement begins immediately after the software license has been delivered. One thing that we need to figure out is do we deliver our goods and/or services at a point in time (once), or over time (as we complete work we deliver it to the customer or as we deliver our goods/services over time and the customer uses them as they are delivered).
Our recognition of revenue would look something like this:
This post is not intended to be all encompassing, but to just give you an idea of some of the complexities you may encounter in recognizing revenue for your company. As you can imagine, the effects of this new regulation can have a significant impact on your financial results, so I highly recommend that you seek out expert advice if you are in doubt or have complex customer arrangements.
This ends our journey down the revenue recognition highway. Thank you so much for joining me! Don’t hesitate to comment on my post or reach out to me directly with any questions.
Susan Nieland, CPA
CFO Solutions, LLC
Here we are again, back on the road to revenue. You’ll remember that we are working our way down the revenue road looking at ASC 606 (that’s accounting lingo for “Revenue from Contracts with Cust…
Here we are again, back on the road to revenue. You’ll remember that we are working our way down the revenue road looking at ASC 606 (that’s accounting lingo for “Revenue from Contracts with Customers”). Up to this point we’ve covered the first three stops on our five stop journey, with the five stops on the road being:
- Is there a contract?
- What do we need to deliver under that contract?
- What is the selling price we’ll get?
- How do we allocate the selling price to different items we’ll deliver under the contract?
- How do we ultimately recognize revenue?
We’ve taken a deeper look into what a contract is, how to determine what our performance obligations are and how to determine the price we’ll end up getting as a result of entering into the contract. Now, it’s time to take a look at how we slice up, or allocate, the selling price between the different performance obligations or items we are selling to our customer.
How do we allocate our selling price? Why is it important?
Let’s look at each of these questions individually. Under our current guidance, which we call ASC 605-25, “Revenue Recognition, Multi-Element Arrangements”, we allocate revenue based upon relative selling price. This is very similar to the new guidance where we will be allocating revenue based upon relative standalone selling price. This is where things can get a little dicey and confusing. In its simplest form, it can be quite easy. The standalone selling price is basically what we would sell the product or service to by itself. When we only have to deliver one thing (whether that “thing” is a piece of hardware or a service we perform for our customer), the entire selling price is allocated to the one deliverable. There are often cases when we bundle items together for sale, and this is when it can become a bit complex. If we have to deliver more than one good and/or service to our customer under our agreement, we are then required to carve up our selling price into sections and allocate a piece of the selling price to each deliverable based upon their standalone selling price relative to the total of all standalone selling prices that we are delivering to our customer under the contract. Think of it like this:
|Contract Price||X||Product A’s Standalone Price||=||Allocation of Contract Price to Product A|
|Total Standalone Price for all Products Sold|
Let’s step through an example:
Say you developed a software product and you license it to companies in the automotive industry. You have sold this product to customers in this industry on a standalone basis for $50,000. You also offer software installation services for those customers that would like to use your professional services division to install the software on their servers. You typically sell these services for $250 per hour. In addition, you offer annual maintenance agreements that cover software updates and support. Customers can purchase these alone, but typically purchase them with the software and renew them on an annual basis for $10,000. Now, you’ve got a new customer that wants to purchase the software, 100 hours of implementation services and one year of annual maintenance. You decide to sell this bundle of products and services for $75,000. If you sold each of these items individually your selling price would be $85,000, but because you want to land this important deal, you offer your customer a $10,000 discount for the bundle. Your $75,000 contract price, and $10,000 discount, would be split up like this:
This post is not intended to be all encompassing, but to give you an idea of some of the complex issues you may encounter with the new revenue recognition rules. “Why does this matter?” you say. It matters, because you will recognize the revenue for each of these products at different times. That’ll be covered in the next post.
Thank you for traveling down the revenue recognition road with me to our fourth stop. At our next stop will be looking at how we recognize revenue. Stay tuned!
Please feel free to comment on my post or reach out to me with comments or questions.
Susan Nieland, CPA