The first value in the profit equation is revenue or sales. This number represents the financial value for the products and services you’ve sold. It is from this number that costs are subtracted to calculate profit. The challenge with revenue recognition is that there does not have to be alignment between when you sell something, when you recognize the revenue (I will be paid), and when you receive cash (I have been paid) (Exhibit 4.1). The most common such situation is one where you sell an item and recognize revenue without receiving payment. This is regularly the case for companies that sell items with payment terms—“pay us in 30 or 60 days.” In these cases, if you sell something in December and recognize the sales transaction in that year, it is possible that you will not collect the cash until the subsequent year in a completely different accounting period.
The worse your receivables situation is, the worse this problem can become. Companies with large days sales outstanding, say 90 days as an example, have, on average, a 90-day gap between when they sell their product or service and when they receive payment for it. In the absolute worst-case scenario, the payment is not received at all. You sell your product or service, acknowledge the revenue, and receive nothing for it. Of course, there are accounting concessions available for such situations; however, clearly, this situation does not reflect the cash flow dynamics of what truly happened and neither do the concessions.
Exhibit 4.1 The challenge with revenue recognition and cash flow is that you can recognize revenue for profit calculation purposes and receive payment at a different time. This creates a disconnect between the revenue used to calculate profit and the cash you receive to run the company
If revenue were truly tied to cash, it would be recognized when, and in what amount, you receive the cash. There are times when the rules and regulations even discourage this behavior such as with gift cards. With gift cards, companies are not allowed to recognize the cash received when the cards are purchased by consumers. Although there are reasons for establishing these regulations, and they make sense for what they’re trying to accomplish, this, and understanding the reason and logic behind the rules, doesn’t change the fact that the transaction does not align with cash flow.
If you use sales as a proxy for incoming cash, it is important to understand this. How and when you receive cash may have little to do with the accounting number you report when you sold that item. If you don’t consider the timing and the terms, your revenue numbers will be disconnected from your cash flow.