Revenue Recognition

When we talk about how much money we "make" in a month, quarter, or year, we're using the standard accounting measure "revenue." We've previously discussed revenue and cash flow in the context of accounts receivable. As a quick reminder, cash flow is when your customers pay v when you pay clients, whereas revenue (in "accrual accounting," in cash accounting it's based on cash flows, but this isn't very helpful) is the sum of money that ought to eventually be paid to the company based on its activities in the quarter minus money that ought to eventually be paid by the company (note for this Lift Letter, there are a huge number of caveats for complex accounting so almost everything below can be incorrect in certain contexts). 

Revenue recognition is the process of determining, based on a set of generally accepted accounting principles (GAAP in the US, IFRS in other countries), whether you must include revenues and expenses for a given period. If you're a lemonade stand and you release monthly financial statements, you make cash exactly when you sell the product so you could just add up the month's costs and revenue and you've got your financial statement.

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But what if you're a crazy lemonade stand and in January you sell people lemonade contracts - but the lemonade can only be redeemed in July of that year - what do your financial statements show in January and July? In this case, you have no revenue in January - your books show "deferred income." You can recognize the revenue when the good or service has been performed, in July. The deferred income is converted to revenue at this time. If you sell an annual subscription contract at the beginning of the year, giving the buyer 1 lemonade per month, you recognize 1/12 of the contract every month. 

What if you become a lemonade tycoon, and you hire a bunch of employees and pay them commissions at the end of the year based on the lemonade they sell in a month, and salaries through the year. In this case, you record as an expense both the salary and your expected commission in each month, because you have an obligation to pay them against the activities in that month, even if you pay it many months later.

If you run a big SSP instead of a lemonade stand, but you have a contractually guaranteed rev share with your publishers - meaning you keep 15% - you can't recognize the 85% as revenue because you never had a right to it. Same with a DSP that takes 15% as a fee from the total billings through its system. But if there's no fixed rev share, the rules could be different based on other discussions.

Why does this matter? We have to issue financial statements and everyone - investors, employees, our bankers - need to be aligned on what they mean. When we show that we made, say, $10M last month, that's based on a common set of expectations about what that number means. We won't get paid that money for a while. It's also possible that some people won't ever pay - they might go out business, for example - and while the revenue stays $10M, we would move some amount from accounts receivable to bad debt and make a sad face. Theoretically, if money were incorrectly allocated it wouldn't have an impact on the actual operations of the company (outside of the finance people getting upset). That means we'd still invoice people the same way, and pay people the same way. But it would mean the numbers that we look at and our ability to rely on those numbers would be degraded, so we wouldn't be able to actually as-effectively project our company's operations. We'd probably also break some covenants with our debt.

If you're a publicly traded company, you're legally obligated to report revenue based on various standards. Companies like Groupon and Salesforce have pushed the limits but generally gotten away with it. Companies like Enron and Parmalat went too far and broke laws. The general idea was that they tried to recognize revenue way too early and defer expenses way too late through complex accounting shenanigans. This would let them get extra debt that they could, presumably, use to make more money and juice their share price. As a result of these and other accounting scandals, congress passed Sarbanes Oxley in 2002, which among other things, holds the CEO criminally liable for the accuracy of a public company's accounting - even if they weren't directly involved. This has had the intended result of having company CEOs make extra sure that the accounting was correct.