We’ve established that the reason a company has assets is to create revenue. Hopefully it is now clear that investing in things that do not convert to revenue or enhance revenue is nothing more than pimping the assets.
A company owns assets to create revenue. So what is revenue?
Revenue is sales. The very first line of the income statement is the sales line, the top line. Don't get confused and call that top line income. There are popular business bookkeeping and accounting packages that mislabel revenue as income. DON’T BE CONFUSED! Income is what you have after you subtract expenses, and it shows up at the bottom of the income statement—the bottom line.
Revenue recognizes the sale of an asset or a service. Revenue does not equal the money collected for the service or sale. Why is that? Well, one reason is that there is often a delay between the delivery of goods or services and the time of payment. Retailer revenue does reflect very closely the collection of actual money, because when a cashier rings the register they are often collecting cash. Credit and debit cards account for most retail purchases today, and cash does not appear in the bank until a few days later.
But the tight time between the sale of the goods and the collection of the money disappears. In business-to-business transactions, the delay between the recognition of the revenue and the collection of the receivable is longer. It can be as short as fifteen days, or as long as ten years. An aircraft manufacturer has a sales team that goes out and convinces an airline to purchase their airplanes. The airline agrees and signs a sales order. Hoo-ray, the sales team made a sale! In reality, it is not a sale, only an order. An order does not represent revenue, it only represents a commitment on the part of the airline to accept delivery of the machine in the future.
A company can record or recognize a sale when it delivers a product or service to a customer. It can also record the revenue and book the sale when the order is placed. The principle is that simple. But accountants have significant discretion in how closely to follow these guidelines. In the case of a manufacturer delivering an airplane, the actual date of delivery is the date the order converts to revenue. For software, it is often the date of the order.
Revenue is not the cash that is collected. The collection of cash is a different event. A company can demand a deposit—an upfront payment of money—with the order. That cash is recognized as revenue, and is credited to the cash on the balance sheet.
The general guideline accountants use for recording and recognizing a sale is that the revenue must be earned. A product company must ship its product. A service company must perform its work. But things aren't always as clear in business as we would like them to be. Consider these examples:
There are no clear-cut answers for any of these examples, because accounting practices differ from one company to another. Project-based companies have rules allowing for partial revenue recognition when a project reaches certain milestones. The consumer-products company may collect money before they ship the goods, even though the promised inventory has not shipped. When do they get to claim the revenue?
A company's top line always reflects the accountant’s judgments about when they should recognize revenue. Where there is judgment, there is room for dispute, and room for nefarious manipulation.
It is important to understand the timing of revenue-recognition on a company-by-company basis. As we highlighted above, retailers are able to recognize positive cash flow almost immediately after the sale. But manufacturers and wholesalers have a lag between when the revenue is recognized and when the cash actually appears in the bank. The reason for this has to do with payment terms.
Payment terms are the length of time between delivery of goods or services and when payment is due. When a seller offers a buyer payment terms, they are acting like a bank, providing credit to the buyer. There are multiple reasons for this practice. In most cases it is simply a way for the buyer to obtain credit that he cannot get from other sources. The seller is willing to extend this credit because it gives them a competitive advantage over other potential sellers.
As Luca Pacioli, the father of accounting, (an interesting video on the subject) would remind us, for every debt there has to be an equal and offsetting credit. If we recognize a sale (a debit of inventory), we must recognize an offsetting credit, either as cash in, or as a credit from another account, called Accounts Receivable. Accounts Receivable is the account that represents the money owed to the company by customers who have bought the company's product or service.
Accounts Receivable is a current asset. It is not real money, only the promise of money. Only when the check is paid and deposited in the bank does the current asset in Accounts Receivable transform into actual cash. Sometimes companies can show strong sales and still be cash poor, because they have not collected the money from their sales. Payment terms are often the reason for this condition.
Quite some time can pass between the recognition of revenue and the actual receipt of the payment. For most business-to-business transactions, payment terms are measured in days, and will be anywhere from ten days to thirty days. In the past decade retailers have begun to stretch terms. Retailers will either negotiate for longer terms with the supplier, or they will just slow pay. It is not unusual for a retailer to demand sixty-day or ninety-day terms. Even with negotiated terms, some retailers, as the final month of the year approaches, will slow down payment so they can show more cash on their balance sheets at the end of the year. While the retailers must show this amount as a liability in accounts payable, they still employ this practice in an effort to puff up their financial performance.
Payment terms are just as important in negotiations as the actual price for the product or service. Customers who pay faster will often get better service if the supplier pays attention to their payment practices. Customers who are slow to pay often find it harder to negotiate favors.
Wrapping up this step of the cycle, a business uses assets to create revenue. The revenue is not profit. To determine profit we must understand expenses.