Editor’s Note: In our continuing effort to impart the most beneficial management knowledge to custom installation professionals, Residential Systems is launching a regular series of advice columns from Darrell McComber, the leading financial consultant to the A/V industry. Through his nearly 25 years of work with A/V retailers, installation firms, manufacturers and independent sales representatives, McComber has formulated a list of the most important questions and answers, related to managing cash, profits and marketing growth.
What is the proper way to recognize income on an accounting statement?
Every time you pick up a newspaper or magazine these days you read that some major corporation is seeking the protection of the bankruptcy court in some form of reorganization. Just as disturbing are allegations of deception in reporting the financial condition of the business. One such deception is to recognize income from signed contracts before any real performance has begun.
Management alone does not always report this overstatement. Sometimes it is collusion between management and their advisors. What is the long-term effect of this deception?
Overstating your income in one period means that you will certainly have to understate it in the future to balance the books. This is a classic case of robbing Peter to pay Paul. Not only does the business have a good chance of failing, but innocent people are often the victims. Also, this frequently results in criminal charges being, which, obviously is not a good thing.
You would think that this problem typically exists in large corporate America, and is not a serious problem with residential contractors in the audio/video industry. Wrong. Many businesses in our industry in some way or another overstate or understate their actual income and, unfortunately, most are unaware that they are doing so. This applies not only to entry-level businesses, but also to those that have substantial sales and history.
What are the motivations for such misstatements? Sometimes the business is undercapitalized, which is a rampant situation in our industry. In such a financial situation you might be tempted to accelerate your revenue to overstate your profits to secure an increase in your line of credit. Perhaps you are looking to remodel or relocate your business and this requires a term loan from a lender. Again you might be tempted to overstate your success. Whatever the reason, this practice is certainly going to get you further in trouble rather than solve your cash flow problems. Business planning based on deception can only lead to trouble.
Unfortunately we also have the reverse situation. In this scenario the business has incurred substantial costs for design, installation, management, materials and equipment, but has yet to recognize the appropriate income for the work completed. This is a very disheartening situation for a dealer who is trying to figure out if they are successful or not.
One of the fundamental requirements I have with my clients is that they do an interim financial statement every month. Another is that they try and match apples to apples as accurately as is possible in a contracting environment.
I know this can be tricky, but it is essential in running a good business. Financial statements that are done quarterly, or for that matter annually, just aren’t acceptable. The horse is already out of the barn before you know you have a problem. Therefore, it is extremely important that you establish a timely system of financial reporting. This should include job costing which lets you know the status of each contract. This must be updated monthly in tandem with monthly financials.
It is important to know what commissions have actually been earned by custom salespeople based on actual margins and on work completed on these contracts monthly. And finally, it is important to reconcile jobs that have been finished every month to properly reward installers and key management people for achieving certain levels of success. These, along with measuring important changes in working capital, are just a few of the benefits of monthly statements. If making these financial measurements is based on inaccurate information you are altering the true results.
In business, a sale is defined as an exchange of goods and services. This is a fundamental premise. As such, the following methods are typically problematic when booking a sale.
* Recognizing income when you have merely signed a contract.
* Recognizing income when you receive a payment on a contract.
* Recognizing income when you reach a certain portion of completion such as pre-wire, trim, equipment, and final.
Why? Because, if you have numerous jobs which you have worked on during the month, but most of them have not reached one of the above levels for recording income, you will be incurring all the design, engineering, and installation expenses but an incorrect portion of the revenue. Remember we want apples to apples monthly.
* Finally, income should never be recognized once the entire contract is completed for the same reason stated above. Monthly financial statements will be all over the board.
All of the statistics that drive financial reporting depend on reliable recognition of income. Are my payroll costs too high? Are my margins on labor too low? Am I spending too much on any particular expense on the income statement? With incorrect income information you can make very bad decisions.
So how should you recognize income? First let me say that once you have a signed contract with a payment schedule based on completing certain aspects of the contract, the arrangement is complete with the customer. The sales order is entered in the system and work is ready to begin. Internal work orders are prepared when actual work is scheduled. At the end of every day the day’s work orders are returned to management and checked for completeness and accuracy. Then the work order is forwarded to accounting to be processed. This results in the system automatically generating an internal invoice against the customer’s deposit and the proper costing out of a portion of the job. In this way you can bill daily for work completed and get the most accurate measurement of how you are doing perpetually.
Are there inequities in this method? Sure, but most of the work-in-progress is recognized daily this way, and you can make reasonable decisions about your business within days after the month is over. I recommend that you discuss this with your internal financial manager, if you use one, or with your independent accountant. Give it a try. It will start to clear up some serious management questions.
Darrell McComber (mccgrpaol.com) works from his home office in Warrenton, Virginia.