Updated: Feb 12, 2020
The problem comes about when you invoice prior to performing the service. If you take the sales invoice value as your revenue without any adjustment then that month’s revenue and profit will look pretty good.
Next month though there’s no sale invoice but you’ll be providing the service whether that’s building a website or paying for the infrastructure and support to use your software.
Annual plans can cause the problem. I’m not going to quibble about monthly plans and which days should go into this month and next. Life is too short until you absolutely have to do this.
Annual plans are great for cashflow - you get a year’s money up front. Cash is always welcome, but from an accounting point of view, the revenue has to be spread evenly over the course of the year (or until they cancel…)
Why? Well apart from the obvious chance they cancel the most important risk is you lose track of how your business is really doing. It is possible, indeed likely, to have lower sales in one month but actually have higher revenue. Let me illustrate.
Recently I did an exercise to move a business from a sales basis to a proper revenue footing. Without me mucking about their revenue (i.e. sales) looked like this;
Would this information have influenced decisions about your business? If the answer is yes the decision would have been wrong. Here’s why;
This exercise was pretty detailed - a 10,000 line spreadsheet and some cute formulas. Probably a day or two to do from scratch but I realise not everyone has my background. So, there is a quicker, easier way to get the same outcome. Ish.
You will need a tool like Profitwell or Baremetrics to do the heavy lifting for you. If you’re happy to take their estimate for your monthly recurring revenue then you can adjust your sales (up or down) in Xero (or your accounting package of choice) by a simple manual journal.
If you sell annual plans then in the early days you most likely have to shift some of your sales forward. You will need a Balance sheet account (it’s a liability - which means you may have to give some of the money back should your customer cancel). Accountants would call it “Deferred Revenue” - I prefer the more descriptive “Income in Advance”. In plain terms it is revenue you haven’t yet earned.
If your Xero Sales are, say £10,000, but Profitwell/Bremetrics say your MRR is £8,500 you need to do a manual journal like this;
Debit - Sales £1,500
Credit - Income in Advance £1,500
This has the effect of reducing your sales account in Xero to the correct revenue amount (£8,500) whilst recognising you haven’t yet earned £1,500 which stays in the Balance sheet until you have earned it.
Later, when your MRR might be higher than your sales, this income in advance is brought back to the Profit & Loss by reversing the debits and credits above.
If you don’t or can’t use Profitwell or Baremetrics then I’m afraid it’s a spreadsheet job. I’ll be putting a template for this up on the site shortly so check in. If you’d like/need me to help drop me a line- email@example.com.