Billing: Fact or Fiction?
Basic revenue streams
I’ve often wondered what the simplest and most useful tidbit of information is, that, had I known earlier, would have transformed years of mistakes into years of success. What is the secret that would have changed the way I saw the business world and made me face reality early on, therefore leading me to make decisions on time?
We’ve discovered that secret by accident, and called it simply: receipts. Over time we learned that, as usual, someone else had discovered it first, and that it’s actually called Revenue Recognition or Services Provided according to international standards.
To explain this concept, we must understand that normal, orthodox invoicing reflects a fact that has already occurred, a service that has already been performed, or goods that have already been delivered. If, in your business, invoicing always occurs after the service has been provided, no problem. Your life is easy and you can stop reading right now and go watch TV.
If, on the other hand, your business has situations in which bills are left up to goodwill, or involve clients who want to spend their budget before consuming the product, or where, for reasons of cash flow or trust between parties, the supplier manages to invoice and collect payment in advance… this article could save your business.
Let’s imagine a company that registers income of $1B with a profit of $50M. In principle we could conclude that the company required $950M to produce $1B. However, the income statements that are recorded in the Chamber of Commerce and other control entities don’t account for whether those $1B actually correspond to revenue earned (goods delivered, projects completed, services provided, etc.) or to advanced billings unrelated to the $950M of costs and expenses.
To illustrate the problem, let's analyze a common situation, especially at year’s end, where clients have a surplus budget and want to spend it so as not to lose it the following year. They request that $100M of the aforementioned $1B be invoiced in advance, that is, $100M that will have no associated costs in the current year from the supplier's standpoint.
These $100M are not actually income: they’re a supplier’s liability towards the customer. However, since the State always charges tax on the highest amount in its favor, (more profit equaling more taxes), accountants don’t rigorously separate account balances and tax balances. And so the invoice gets recorded as income.
If we were to subtract those $100M of advance invoicing from the $1B of total income, we’d see that the services provided during that year were equivalent to $900M. Therefore, with costs of $950M, reality would show a loss of $50M. If the advance payments were $200M or $300M, we’d be talking about losses of $150M and $250M.
To an unsuspecting board member or a tax auditor unaware of the nature of the business, this situation might go unnoticed. Years could go by showing the business breaking even or making a profit when there are actually colossal losses hidden by advance payments during the year-end quarter.
Fortunately, eliminating this problem is simple:
Always invoice a service already provided; that way you never record income that hasn’t yet been earned.
Use prepayment instead of advance billings. Technically, this is money a customer gives in advance without being invoiced and is therefore recorded in balance sheet accounts rather than an Income Statement.
Finally, the simplest option which maximizes cash flow and depends on no one else is the issue of management accounting for services provided.
Management accounting for services provided allows you to know your actual output and benefits from actual costs. Simply assign an economic value to the real earnings you had that month, regardless of whether they were billed or not.
For example, if 40% of a $100M project has been completed by the end of the first month, we will say that in that month you produced $40M of income.
In any case, try to maintain additional control from the cash flow, reserving any payment received in advance in a savings or trust account separate from the overhead account. Some less drastic but not particularly better alternatives are reserving only corresponding costs, or costs plus operational expenses. Either way, if you’re billing in advance, it’s likely because you need cash flow, so I doubt you will be strict enough to implement this last control.
To determine this value you can implement various strategies. The simplest is an inside end-of-the-month company meeting where progress of each project is determined and its economic value is found. A stricter one is to request the customer’s approval of said advance; here the matter avoids inside manipulation and also places the company at the customer’s service.
Once this process has been carried out you can add all the monthly income, subtracting monthly expenses and costs to determine if you are working with a company that is truly creating value or one where the financial phenomenon of advance payments and others cover over one hole by digging another that can’t yet be seen.
The ramifications of not taking this into account are endless. Imagine a company that by December 28th has rendered services for $1B COP with an actual net profit of $100M. A customer requests an invoice (including prepayment) for an additional $200M. This company will close the period with an income of $1.2B and $900M of expenses, showing a profit of $300M, giving rise to almost $100M in taxes. That is, it unnecessarily pays taxes on $200M of supposed profit when in reality costs of providing the service still must be spent, and, assuming they are similar to previous expenses, would come to $180M, for a profit of $20M. Advanced billing caused you to pay taxes on $200M instead of $20M.