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Issues of Revenue Recognition Method for Services Companies

By Sachot Jean-Baptiste, 11:15 AM on September 30, 2016

The service sector is the one that is most affected by the differences between production and invoicing. Although the manufacturing of goods involves a more direct link, a more immediate and concrete correlation between production and invoicing, the service sector requires more complex financial management. Some work phases resulting in the production of a service do not give rise to production that is immediate or directly quantifiable.

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However, it is advisable to integrate these phases into the calculation of the final revenue. Such is the challenge of the choice of revenue recognition method for a service company. Choosing a revenue recognition method suitable for every service offered as part of your business means equipping yourself with essential tools for the good financial management of your service company.

Invoicing methods and revenue recognition, two very distinct problems

It is advisable to first remove ambiguity, which is often a source of confusion. Different invoicing methods and different revenue recognition methods constitute two very distinct elements in effective financial management. Although general coherence in management involves parallel consideration of these two problems, they are not necessarily linked, and the corresponding techniques and methods are totally different.

Different invoicing methods

When it comes to invoicing methods, we are talking particularly of:

Billable hours

This method involves the simple invoicing of each hour or day of service provided in the context of an individual, signed contract. This simplicity (one day worked equals one day billed) offers total financial visibility and a guaranteed margin for the service company.

Project billing

This is a method that involves billing a client for a fixed overall amount, based on an evaluation and prior negotiation, even if the service company spends more time on the project than estimated.

The client retains control of the final price, but the risk of poor evaluation upstream involves the possibility of tight and even negative margins. It's a riskier method for the service provider.

Subscription billing

This billing method relies on the client's trust in the service provider and involves the client taking out a subscription, usually on a monthly basis, enabling them to access the services as needed at no extra cost. It's a billing method that offers great visibility to both the client and the service provider. However, the latter must manage a risky period of transition when opting for subscription billing. The amounts that the company used to be paid in a single payment (or several) will then be paid in a staged way over time. It requires even more rigorous management of cash flow.

The different methods of revenue recognition

Beyond the billing methods, the revenue recognition methods will govern the rhythm at which the company will be paid. Typically, there is:

Completed contract accounting

This involves posting the revenue only when the services become billable, whether at the end of the project or at intermediate billing milestones. This recognition method, that has proved to be fairly prudent, is nevertheless not favoured by professionals from the sector because it gives a momentarily skewed view of the company's performance. In addition, the stages involved in being billable (i.e. for the revenue to be recognised) must be validated by the client, whereas the costs do not wait for the client's validation.

Percentage of completion accounting

This method of recognition involves posting the revenue, along with the associated margin, gradually during production, and independently of how the project is billed.

Instalment accounting

This method involves recording the revenue in the profit and loss account according to the period covered by the service.

The popular vote is for the percentage of completion accounting method

Although it is advisable to choose a revenue recognition method adapted to each service, the percentage of completion accounting method is the order of the day for fixed price projects. This method enables the linearisation of revenue with more precise visibility of margins and the company's performance.

This method also offers a more secure variant, known as sales-basis, as opposed to the "theoretical" percentage of completion. This variation makes it possible to achieve 100% of the recognised revenue, once the service is actually completed. That is, when there is no work outstanding and no further costs will be incurred. This avoids the exponential increase in costs (and a decreased margin) when the daily budget has been spent and all the revenue has already been recognised. With this variation, the revenue accounting is slower, but more reliable.

Whichever revenue recognition method is considered, its optimal application requires the use of a modern, efficient Information System. In particular, it is essential to have access to software capable of calculating payment pending invoices and profit centre accounting, and then of automatically entering them in the accounting system. Operational staff should benefit from modern dashboards with a drill-down feature enabling in-depth focus and analysis of data.

Choosing the right revenue recognition methods for a service company, therefore, takes on the vital challenges of the optimisation of financial management. The ability to free yourself from the "invoiceability" of projects, the agility and responsiveness of the company are notions that are directly correlated to the choice of revenue recognition method. In a sector that is now globalised, particularly competitive, boosted and transformed by the arrival of the web, a service company will develop thanks to an Information System that is up to the task. This must include the most efficient integrated management tools.

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