Burned Before Earned

At my house, long before the crocuses start pushing their way up through the New England snow cover, the first harbinger of spring comes by mail. It's the arrival of the mowing contract from my lawn service with its prepayment discount offer: 5% off the total annual fee if I prepay it all by March 31.

This has always seemed to me to be a reasonable trade-off — the landscaper gets some working capital to start his season, and I save $60 over six months. In the back of my mind, however, I can't help thinking, "What if he goes out of business between now and October?" Knowing something about the economics of the business — grass (that is, the real stuff that makes lawns) hasn't changed all that much since I was making the rounds of my own lawn customers as a teen-ager — I figure that if he were really pressed for cash he'd be offering 10% off. So I usually take the deal.

This year, however, he gave me cause to pause. The invoice arrived in mid-February and the 5% discount offer expired on February 28th, a month earlier than usual. "Hmm, does this mean that he needs my cash just to get through the winter?" I thought. "Or, alternatively, is he doing so well that he's trying to discourage me from taking the discount, preferring instead to add 5% to his bottom line?"

Companies that work on a prepaid basis are notorious for spending their money before they earn it. Any entity that invoices up front — think magazine publishers, trade show organizers, software and hardware providers with annual service contracts — may collect cash in advance, but they don't earn revenue until they deliver the product or service.

This, of course, is Lesson 1 of Accounting 101 — the difference between cash and accrual accounting. Basic though it may be, many managers fail to appreciate its implications in practice. Here are five elements of the basics of accrual accounting:

1. Prepaid revenue is a liability — You may collect cash in advance which is recorded as an asset on your balance sheet. But the offset is a liability for the full amount that you have collected in advance — you have a liability to deliver that product or service now that you've been paid.

2. Revenue has to be earned — Sales can be recorded on the income statement only to the extent that you have provided the product/service to the customer, whether or not you have been paid for it. If it's been prepaid, you record the sale by moving the invoiced amount from the balance sheet liability account to the income statement revenue account. If, instead, you are to invoice the customer, you record the revenue on the income statement and offset it with an account receivable on the asset side of the balance sheet.

3. A purchase order is not an accounting event — It's an order, not a transaction, either when you receive it or when you place it. When your customer sends you a P.O., you count it as revenue only when you deliver against it. When you send out a P.O., you expense it only after you receive the goods/service.

4. Revenues and expenses must be in sync — To get an accurate reading of your profitability, all of the revenue that you generate in April should be matched by all of the direct costs that you incur in April related to what you shipped, adjusted as necessary for any work that may be in progress over the end of the month.

5. Buy now, pay later — When you buy on credit, you incur a liability in the form of an account payable as the goods (for resale) go into the asset account called inventory. Under the matching principle, however, this does not become an expense until it is taken out of inventory and processed for sale.

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