Revenue is recognized when the company has transferred control of the goods or services to the customer, meaning the customer can now benefit from them. This is BYFIQ. Wealth and success come from understanding how finance works in business, and together we'll explore the most important topics to 10x your financial results. My hope is that we can work together soon. Please share and enjoy.

Today I want to talk about revenue recognition, because this is a pattern that I've seen over the years working with small to mid-sized businesses, and that is their revenue that is recorded in their accounting system doesn't match the economic reality of the business and, as a result, a lot of business owners really struggle to understand their true financial position and their health. Let me explain. So I'm working with a company recently and they use QuickBooks, which is not abnormal for small to mid-sized businesses, and there's nothing wrong with QuickBooks. In fact, quickbooks, xero, oracle whatever accounting system you use falls prey to the same exact trap that I'm about to explain, and that is when you create an invoice in these systems, if you're on a cash basis, it gets recorded as revenue immediately. So this may not sound like a big problem, but let's just say you're a construction business and you collect deposits on your work before the work is performed. And in order to get that deposit, you have to send an invoice to your customer. So you go into the system, you create an invoice for, let's just say, 30 grand. Let's just imagine it's a $90,000 contract and you're billing them for a third of the contract upfront so you can secure their position and you can order materials, et cetera. So you do that, you send them this invoice for $30,000, but the job isn't going to start until the next month. So the invoice is created and when you pull your financial statements, guess what? It shows up as revenue. Well, because the job hasn't started and let's just imagine you haven't incurred any material cost or labor costs, it shows that you have $30,000 in profit. Now I'm simplifying here and I'm just imagining that the organization doesn't have any other jobs going on. So you have revenue of 30 grand is zero cost and therefore $30,000 in profit. And the owners, if they don't understand differently, they celebrate Yay, we're so profitable. Look at all the money we're making.

Then let's imagine the next month the job actually starts, but you can't bill the customer for the next third until the job is halfway done, which isn't going to occur until the following month. Well, now you're starting to incur labor costs and material costs to perform the work. So in month number two you show a massive loss. Let's just say you incur $25,000 in cost. Well then you panic because the month before you're making all this money and now you're losing money. Now I'm being extreme here with my example, but hopefully you get the point.

When you're on a cash basis, you record and recognize revenue as soon as an invoice is created. When you're using accrual accounting, you recognize that revenue when the revenue is actually earned. Okay, so you may be wondering what needs to occur in order for revenue to actually be recognized and recorded as earned under generally accepted accounting principles under GAAP. Well, there's five things. Number one there must be a contract in place. So the company and the customer must have an agreement in place that creates enforceable rights and obligations. So it could be a contract, it can be an engagement letter, but some type of contract must exist that outlines certain terms of the contract. Number two the company must deliver on its promises. In other words, the company has to identify what goods or services it promised to provide in the contract right in step number one, and then make sure it fulfills those obligations. But it doesn't stop there. Number three the price has to be agreed upon. So the total amount that the company expects to receive from the customer for the goods or services must be clear. You can't just say, hey, we're going to come in and we're going to install your landscaping, plant trees and you'll pay us some type of money. You have to be very specific. You're going to pay us $90,000, and here are the terms, all right. So that's point number three. Number four you have to allocate the price. If necessary, if the company promised multiple goods or services, the price must be divided accordingly for each item. That's really critical and that's going to be helpful when it comes to revenue recognition, because you'll know from an accrual standpoint what to record when the work is actually completed and technically earned.

Number five revenue is recorded when delivery happens. So revenue is recognized when the company has transferred control of the goods or services to the customer, meaning the customer can now benefit from them. So this is what I mean by fulfilling the work, by actually performing the work or putting it in place. So when you send an invoice for a deposit to a customer, guess what? You haven't earned any of that money. And if you record it as revenue on your books, guess what? You don't show a liability. And you have a liability. So if that customer ever comes back and says hey, I want to cancel the project, give me my money back. Well, unless you have a clause stating otherwise, you have to give them their money back, right? And so therefore, if you've already spent it because you're just relying on your financial statements and you're making decisions based on profit and not cash flow, you can get into a lot of trouble.

In summary, revenue can only be recorded once the company delivers what it promised, knows the price and expects to be paid. Otherwise it's not revenue. And this seems like a very simple concept, but a lot of people struggle with it because when you add project on top of project on top of project, it creates a lot of layers and it's not as simplistic as the one example that I gave you, where you're listening to this and you're like okay, steve, that's very simple, I get it, but when you have a lot of projects going on at once, it could get really tricky. So that's what I wanted to explain today the keys of revenue recognition, because if you're not accruing for your revenue correctly, your financial statements can lead you definitely astray, either both in a positive or a negative direction.

You could be spinning out of control because you think you're going bankrupt, but it's actually because your revenue is not being recorded correctly. Or you may think you're so rich and you have all this cash and you go out there and buy all this bling bling, or you go buy this fancy car and guess what? That money's not yours and after you start incurring costs, you're going to run out of cash. So I don't want this to happen to you, and that's why I wanted to point out this very important concept. That's all I have for today. Be sure to share if you got value out of it and in the meantime, take care of yourself. Cheers.