REVENUE RECOGNITION
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Background and challenge
A Home Improvement company “hit the jackpot”. Through different sources and government programs, they were able to increase sales significantly. Within one year, they grew from $3M operation, to $10M+, all from Home Improvement projects, averaging $50K revenue per project.
When we were first introduced to the company, the story we heard was that the company is doing great and just going through some “cash flow crunch” and needs some help on this. The owner’s main idea was to have us assisting with obtaining a quick bank line of credit, to be followed by raising Private Equity investment.
Analysis
(At that time, the company had multiple issues. Here I will focus on the Revenue Recognition issue)
As a first front of attack, we tried to create a quick 12 weeks cash flow projection. As part of that exercise, we reviewed the Accounts Receivable. Through this we learned about the company’s flawed way of recording revenue –
The company’s sales people close deals on a daily basis. A significant portion of these deals, though not the majority, is cancelled within the following 10 weeks. The rest of the deals would hit ground within the following 4 to 16 weeks.
The company recorded the revenue from these deals as they were “closed” or on the first day they were signed by the customer.
This created a very inaccurate picture of the revenue and made it look much better – great sales, with growing AR that probably could be funded. However, that was not the case – some of these “receivable” became later on cancellation. Others became real receivable much later.
Overhead and commission expenses however did accumulate in a fast pace on a monthly basis. In addition, COGS were not aligned to revenue. As long as the rate of signing up new customers, on a monthly basis, were higher than the previous months, this “misalignment” between revenue and COGS got worse, as every month, more expenses got “pushed” the future months, compare to those recognized.
Solutions
We implemented three changes on the accounting policy side –
1. We implemented Month End accounting and closing within 10 days after the end of the month. By doing that, management received accurate and current information and status of their business.
2. We transitioned to full accrual basis, reflecting true business result.
3. Implemented WIP (Work in Progress) management, effectively recognizing only revenue for portion of projects that have been performed and created customer liability.
Results
In order to be able to turnaround a business and lead to success, the first step must truly understanding the situation, facing the brutal reality.
The company indeed had an amazing growth but completely missed the dynamics of the growth, as their accounting policies obscured the real financial results.
Implementing acceptable accounting and revenue recognition principle, coupled with routine and timely reports, provide the management with the correct picture and ability to make the right decisions.