Closing the GAAP Gap
It is important for the sales and finance teams to mutual understand how sales activity maps into GAAP financial statements.
- Published by Craig Kirsch
on Thursday, May 7, 2020
Every month your sales team has a target. The sales process concludes when a sales order is received. The sale team adds up all of their sales orders for the month and reports them to accounting. They are focused on one thing...did we hit our targets?
While the sales team is focused on numbers, there is more to the story. In fact, the story impacts not just the sales team commission but impacts multiple departments throughout the company and a critical look into the future.
The sales team is managed by the sales department; they either hit their numbers or they do not. As the CFO, your job is to report the facts...just the facts.
However, the facts (according to GAAP) may tell a different story. New bookings may not have any immediate impact on financial reporting thus creating the first disconnect between sales and accounting. For example, if the sales order has been booked, but we have not invoiced the customer or satisfied an obligation, it's like it never happened for financial reporting purposes.
What a shame...your sales team is working their tails off (or not) and they have nothing to show for it in the financial statements.
But wait a minute, this is important information. Although the information may not make it onto the Income and Loss Statement or Balance Sheet, it provides important insights into the future. Of course, you know it is there and the sales team' considers their job done, but there is a disconnect between what just happened and what is reported on the financial statements.
Over time, this disconnect "gap" closes (performance obligations are satisfied and recognize revenue) but it happens. In other words, what just happened is viewed sometime in the future and viewed through a rear view mirror.
Adding to the disconnect is the reality that the long-term impact can only be interpreted by the wizards of GAAP. It is highly unlikely that the sales team is tracking deferred revenue over time. They have limited knowledge or concern about how ASC 606 dictates when revenue is recognized. In reality the sales team has moved on to next months numbers (adding new elements of disconnection) and management is left piecing together new bookings, backlog and revenue projections (revenue waterfalls) to assemble meaningful analytics.
Closing the GAAP gap
CFO's are tasked with not only reporting in accordance with GAAP but also with providing valuable insights to the entire company. Unfortunately the disconnect between what can be reported in the financial statements and other information that is meaningful to management can distort the long-term picture of the company.
Since accounting systems are designed for financial reporting valuable information must often be presented through other reports. To get the full picture, the CFO must get information for sales, operations and accounting and piece it together to get a blurry picture of a critical information.
Let's look at the disconnect identified between new bookings and financial reporting. To help close this gap, there are three reports that are useful:
- New Bookings Reports
- Backlog Reports
- Revenue Waterfall Reports
- MRR/ARR/Churn/Average Customer Life
This is report provides information related to new bookings for the period. It is independent from GAAP and it provides a valuable gauge of new activity. The information can be compared to targets, prior months or prior years to determine the effectiveness of the sales efforts.
This report can be easily generated from your sales order report or from your CRM system. Here is an example of new bookings (as compared to revenue recognized by month):
Although the new bookings number can provide a high level look at the new bookings, this information is more valuable on a more granular basis. For example, the ability to look at new bookings by product sheds insight into product mix and pricing structures and by channel allows you to evaluate the effectiveness of sales channels.
Backlog is a reporting metric important to monitoring a company's expectation for future performance. Backlog includes not only the new bookings but also the value of of all contracts where performance obligations have not yet been satisfied (e.g. recognized as revenue).
Backlog includes the full value of recurring revenue (not yet recognized) and value associated with non-recurring revenue such as services. Since it is not contingent on invoicing or collections, it does not show up on the financial statements (e.g. deferred revenue). Backlog gives a clearer picture of future the total contract value of all contracts.
Having this information available by product and service allows management to gauge anticipated revenue over future periods.
Backlog can be broken out to separately show the MRR/ARR component related to recurring revenues from the backlog related to non-recurring revenue. This information is important to help companies project future ARR/MRR taking into consideration backlogged projects.
Revenue Waterfalls are an important since they convey the progress and growth of a company's bookings and revenue streams. Revenue Waterfalls are a valuable tool for internal analysis and provides an easy to comprehend look at the company's overall growth and future outlook.
The Revenue Waterfall outlines illustrates the value of all contracts and should include all services. This report provides a look into the future of the projected revenue stream. By including all sources of revenue, management can easily see anticipated non-recurring revenues (e.g. implementation, training, etc.) to ensure that the project is on track and the anticipated resources are available.
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