By Sean Hickey, Senior Consultant
Every company where I have done SOX (Sarbanes-Oxley Act) compliance testing has the same problem: Their over 90 days past due accounts receivable stunk. In fact, they all seemed to think that having 5% over 90 (and sometimes even close to 10%!) is normal.
These same companies also had a sea of revenue recognition journal entries on the backend of their order-to-cash process, and saw this as a normal and acceptable practice as well.
Most importantly, they failed to see the connection between these two things.
I’m here to tell you that all of those revenue recognition journal entries are neither normal nor acceptable … and if you change your order-to-cash business processes in a way that eliminates them, the percentage of your A/R that’s over 90 days will plummet.
The revenue recognition problem
It is currently very popular for organizations to re-engineer their Order-to-Cash or Configuration Quote-to-Cash process in order to optimize their supply chain capabilities. The focus here is usually on providing on-time delivery to maximize customer satisfaction, while also reducing inventory.
Although customer satisfaction is extremely important, the lost opportunity I see is these re-engineering projects tend to leave Finance out of the discussion. Finance is then left to manage revenue recognition as a back-office accounting process.
This usually means using Excel workbooks for creating journal entries and reconciling the Deferred Revenue balance sheet account. Other times companies use expensive backend applications that are bolted onto their supply chain ERP (Enterprise Resource Planning) applications to create general ledger entries that manage the revenue deferral / revenue recognition process. These practices create material differences between financial reporting and the results the ERP system provide.
What no one is talking about is how to change the process at the front end so that these revenue reconciliation entries won’t be required at all. After all, journal entries are essentially “defects with root causes attached,” that can be traced back to the upstream process that led to them.
If you deferred revenue you probably did not collect it. Why not?
Getting the cash and recognizing revenue are not two separate activities
The timing of revenue recognition is a huge component of Internal Controls over Financial Reporting (ICFR) SOX compliance by the SEC and other agencies, and the opportunity is to be in compliance on a daily basis. And of course SOX compliance goes hand in hand with the Financial Accounting Standards Boards’ ASC (Accounting Standards Codification) 606. One of the most common errors I see violating this standard is invoices being created that are not yet collectible. Finance is then left to correct the revenue recognition error on the backend.
All of this leads into the first rule of finance, which is to get the cash, while accurately reporting revenue recognition on a daily basis. However, the more revenue recognition reconciliation entries you need to make in your general ledger or journal, the greater the risk that you are out of ICFR compliance because your revenue recognition is inaccurate.
A better approach: Get back to basics
Rather than continuing to invest in people, processes and systems on the backend, all of which are only managing defects, you’ll get a better return on investment by improving your Order-to-Cash or Configuration Quote-to-Cash process. Your goal should be to achieve revenue recognition accuracy without using backend entries based on Excel worksheets or bolt-on systems and, in the process, greatly improve your aged receivables.
When Finance and Business Operations work together you can eliminate the root causes behind a revenue deferral journal entry. A key point here is that before recognizing revenue, an invoice has to be collectible. As the Security and Exchange Commission put it in bullet point four of their December 1999 SAB (Staff Accounting Bulletin) 101, “Collectability is reasonable assured.” This is no different now with ASC 606.
For starters here are a few ideas to align your shipment, invoicing, collections and revenue recognition processes in an integrated way:
- Stop shipping partial deliveries and/or creating partial invoices. When an order is coded as a “partial delivery” this means you are shipping multiple line items on an order, sending partial invoices, recognizing that revenue at the time of invoicing, and then watching it all go straight to your aged receivables.
The invoice is not collectible because the entire order has not been fulfilled. - Avoid accepting non-standard pricing terms, such as giving away 12 months of service and support for free as part of a hardware sale. A better approach is to avoid giving away services for free. Instead, discount the hardware more or apply a discount on the services. This keeps goods and services as separate performance obligations which can then be invoiced separately, and avoids the need to do an unnecessary revenue value calculation.
- Require every carrier to provide proof of delivery. Not only does this help the collections function minimize A/R disputes, it also provides clear evidence for revenue recognition at a transaction level.
- Code every order to invoice as FOB shipping point. Remember, the order = the invoice = the revenue. To recognize revenue at the time of shipment, the order should be coded to invoice as FOB shipping point. This eliminates in-transit inventory.
With this approach if there are 12 items on an order you are shipping all 12 items at once. You get one FOB shipping point order with one net-30 invoice. Your revenue is then recognized as the shipping point. Of course, this creates back pressure on manufacturing inventory, but it is the right financial accounting call vs. having portions of the 12 items on an order sit as open A/R balances that will inevitably age. Because no revenue deferral is required, no backend journal or general ledger entries are required.
Additional benefits of this approach include:
- Lower overhead costs for your monthly revenue close. Since revenue recognition is now essentially closed on a daily basis, monthly revenue can then be closed on workday one, with minimal use of journal entries.
- Less manual effort. As a result of having few journal entries, your general ledger for financial reporting stays in sync with your Order-to-Cash and supply chain ERP systems. This results in less manual effort, if any, to provide financial reporting results to management.
- Lower ongoing costs. This approach will most likely eliminate the need to bolt an expensive backend revenue recognition application onto your ERP system. The use of Excel can then be limited to your complex multi-element (i.e., hardware, support, services, installation, consulting and testing/acceptance, etc.) orders.
Plus, of course, your army of revenue recognition accountants can be redeployed to more important tasks.
Some of this may require an IT investment
CIO Professional Services can help you get rid of your over 90 days past due accounts receivable problem by designing and implementing a better approach to Order-to-Cash from the process and systems perspectives.
About Sean Hickey
Sean Hickey is a business process improvement leader and business application implementation expert with 25+ years of industry and consulting experience developing and implementing transformative business strategies. Clients appreciate his ability to develop the “big picture” strategy and then drive it down to executable tactics for realizing both immediate and sustainable results.
About CIO Professional Services
Based in the San Francisco Bay area, CIO Professional Services LLC is a top-rated Information Technology (IT) consulting firm focused on integrating Business and Information Technology. Our consultants are all hands-on executives who are veteran CIOs and Partners of Big 4 consulting firms. Companies come to us seeking assistance with their information technology strategy as well as for interim or fractional CIO / CTOs, and negotiation and program management/project rescue assistance.
