The small and emerging business owner’s primary focus is on the P&L statement. It is hard to refute that growing revenue and minimizing expenses is the key to staying in business. However, success for the small and emerging business owner demands more than generating more sales and keeping costs down. The business environment demands strategies that address a wide spectrum of issues from financial statement presentation to solid operational business strategies—areas dependent on P&L policies. If the small and emerging business is publicly traded, for instance, the need to maximize shareholder wealth (keeping the stock price high) will be a major priority. Initiatives related to pleasing shareholders and laying the foundation for solid growth often conflict. Private, closely held companies do not face pressure from absentee stakeholders; however, making good decisions will depend on an understanding of the dynamics of revenue and expenses in the business.

The small and emerging business owner must view the business as a cash machine. Revenue represents cash in and expenses represent cash out. Employing accrual accounting, however, distorts this paradigm. Sometimes complicated devices are used to translate activity or expected future activity to revenue. Acceptable methods for accruing revenue are often employed in questionable ways, resulting in a distorted financial picture of the enterprise. Methods used in percentage of completion accounting, sales-type lease accounting, and accounting for long-term subscription revenue are examples of methodologies that create a gap between the P&L (revenue) and the balance sheet (cash). Accrual methods for recording expenses— depreciation, deferred taxes, and restructuring charges applied arbitrarily can paint a confusing if not deceptive picture of the organization. This dilemma drove the accounting profession to develop the parameters for the statement of cash flows— which is now a standard part of any formal financial statement package. The small and emerging business owner eventually will have to apply GAAP properly to the enterprise. Strategies that focus on minimizing the pitfalls of recording revenue and expenses are a must if external data customers are relying on GAAP financial statements. Meeting this need will mean developing strategies that focus on generating, analyzing, and recording revenue in a way that benefits the company and stakeholders. Additionally, initiatives will have to be developed that focus on the recording and analysis of expenses.

Frenetic day-to-day activities of the small and emerging business may prevent owners/executives from crafting mid- and long-term strategies. Immediate needs can be accommodated by optimizing reporting and analysis initiatives as they relate to the P&L. Understanding the dynamics of the two major P&L classifications— revenue and expenses—and how they take shape in operations will provide a head start in creating a solid foundation for analysis and decision making.

Revenue

The recording and analysis of revenue is a challenge for any organization. A complete understanding of the business is the first step in translating events and transactions  to  revenue.  Revenue  issues  can  be  broken  down  into  two  groups: presentation issues and operational issues.

PRESENTATION ISSUES 

These issues relate strictly to the recognition and recording of revenue. They are particularly acute for public companies or those that have some sort of reporting requirement as a result of financing or absentee ownership. The need to employ GAAP is the primary motivation for examining presentation issues. Considerations in this regard are:

- Applying uniform revenue recognition policies. A good indicator of the suit ability of revenue recognition policies is the disposition of the receivables created by the sales. Are they being paid in a timely manner? Are they recorded in a way that allows them to be aged properly? Monitoring a natural offshoot to revenue such as receivables provides an indication of whether the company is recording revenue events properly. The ability to budget and forecast revenue also will require intimate knowledge of the business. Knowing whether to ramp up inventory in anticipation of customer needs and vice versa depends on the organization’s skill at prospective reporting.

- Applying accurate revenue recognition policies. The small and emerging business owner must determine if, from a GAAP perspective, the methodology for revenue recognition fits actual events and/or transactions. Nothing creates angst for business owners more than auditors or examiners paring back revenue because of a methodology that doesn’t fit the revenue event. This occurs if the revenue is not characterized correctly from the start. Basing budgets and forecasts on inaccurate revenue recognition methodologies will create a ripple that will affect inventory ordering and capital expenditures. To avoid problems, guidance from accounting professionals or industry experts is key. Basing internal analysis on numbers that are derived in the same way externally reported numbers are recorded also will cut down on confusion in decision making.

- Using aggressive versus conservative revenue recognition. In many cases GAAP allows for a spectrum of treatments for events and transactions.

Nowhere is this continuum abused more than in the revenue recognition area. The temptation for small and emerging business owners is to rely on the judgment of auditors to determine whether revenue recognition is fair. Auditors, however, rely on management representations in forming their opinions— representations that business owners agree to (unwittingly or not) when they sign the letter of representation at the end of the audit engagement. Aggressive revenue recognition policies are used all too often when a company seeks to meet or exceed the expectations of the analyst community. Again, consulting a qualified professional who understands the company’s business will serve the small and emerging business owner’s best interests.

OPERATIONAL ISSUES 

These issues are the practical aspect of revenue policy. All high-level executives agree that the presentation of results to outside parties is important, but small and emerging business owners have a greater need to set sound policies for evaluating the business and charting a course to prosperity. This need can be addressed by tackling the following operational issues:

- Positioning for recurring revenue. Businesses approach their markets in two
ways: making the sale and cultivating more sales. The nature of some services and products, however, may allow for quick saturation of the market. This is the case with businesses that sell systems or solutions that may be good for the life of the company. An example is a home security system or antitheft system for businesses. These products represent large one-time outlays of cash for the customer but offer little room for future revenue streams for the selling company.

High-ticket items like these often work against the businesses selling them as they fall victim to the allure of big one-time sales while failing to cultivate their market in a way that allows for future revenue streams. The business must be able to evaluate future products and services that augment such offerings. Revenue strategies may be put in place that offer less expensive one-time outlays of cash from customers but require a steady recurring revenue stream in the future. The business may adjust the pricing on a security system so that while it receives revenue up front on the initial sale of the system, they also can lock customers into long-term commitments to buy monitoring or maintenance services. In this way the finance function should be on the point in providing data and a platform to analyze all potential alternatives.

- Recognizing volume versus quality of revenue. The pressure to make sales and increase revenue may force the small and emerging business owner into short-term decisions that may not be in the company’s best interest. Chief among these dilemmas is the question of quality versus quantity of revenue. Does producing and selling a lot of products with a lower selling price (and inferior  margin) make more sense than selling less of a higher-priced (higher-margin) product? Although a sale is a sale, what will pursuing one type mean compared to pursuing the other? Business owners often get sucked into alluring revenue patterns that hurt the organization in the long run. The organization should be looking hard at the impact of high-volume, low-quality sales versus lower-volume, high-quality sales. The finance function must be positioned to support decision making in this regard. A well-informed policy will not only enhance the prospects for profitability over time but build a more stable, reliable base of customers.

- Negotiating the sale effectively. The small and emerging business owner must be aware of variables in pricing schemes and know how a negotiation will impact the resulting revenue. High-end (priced) products or services typically demand a face-to-face negotiation with customers. The salesperson must be educated on the impact of trade-offs on the deal before going into negotiation. Will it be necessary to cut product/service prices to generate sales? Should add-ons, freebies, or give-aways be used to induce sales? Should the company demand cash for sales or give generous terms? The intent of the sales experience is to create satisfied customers. Contrary to conventional thought, the customer is not always right. The finance function must play a significant role in developing sales contracts and sell sheets to prevent salespeople from turning a good sale into a long-term burden for the company. Similarly, it should yield information on all aspects of product and service pricing that should be a part of training programs for salespeople.

- Interpreting analysis and results. The finance function must lie at the center
of evaluation and measurement of products and people. Policies that are used to motivate sales organizations or determine the viability of the product/ service mix should rely on input from the finance function. Challenges in comparing sales activity across geographical areas for the purpose of bonus structures and incentive plans should also be controlled by the finance function. Does generating $1 million in sales in Racine, Wisconsin, require the same amount of effort as generating the same in New York City? To what degree do demographic and economic factors alter this comparison? The same goes for evaluating the pricing of products and services. Policies impacting these areas must be developed based on accurate and timely information.

Costs/Expenses

Preservation of capital is imperative at the early stage of the business. Therefore, it is important to be aware of expenditures and their purpose. What is the nature of expenditures? Are they capital expenditures, for furniture and computer equipment? Or periodic expenditures, for payroll and utilities? Unlike revenue, expense considerations and strategies often trail expense events. Sound policies related to expenditures will address many cash flow and working capital considerations as well as earnings goals and expectations.

Approaching expense policies is similar to establishing revenue policies, in that a complete understanding of the business is necessary. The need to establish presentation-oriented policies is key if the company is publicly traded; however, the organization has a greater need to analyze (and alter) expense patterns and/or manage the circumstances that give rise to expenses. The development of expenseoriented policies will fall more into the operational/analysis realm than the financial  reporting  area  for  the  company to receive true success in this area of strategizing. The next topics provide guidance for the small and emerging business owner to start the development of expense policies:

- Striving for meaningful analysis. How good is the organization at interpreting costs and expenses? Are tools in place that can interpret expense activity over time? How will the organization be able to interpret cash outflows that are detrimental to it? The finance function will have to be equipped to classify expenditures properly and to develop meaningful analysis tools. Developing analysis tools that track run rates (the results of specific expenses over an extended period of time) or provide comparisons between current- and prior-year activity (bilevel variance analysis) or current, prioryear, and budget analysis (trilevel variance analysis) will go a long way toward managing events that give rise to expenditures. Having the capacity to segregate expenses and compare them to different parts of the P&L is also important. Examples include capping operating expenses at 20% of revenue or pegging Research and Development (R&D) expenses at 15% of revenue. Expense goals like these are powerful measures that are easy to communicate to the organization and easily understood. Such policies are heavily dependent on the finance function for development and maintenance.

- Managing the timetable for paying vendors. The organization as a whole must make a commitment toward treating vendors in a consistent manner. Doing this includes managing payment terms. The challenge for most businesses when paying bills is deciding whether to pay early and enjoy discounts or to exercise terms and preserve cash. The business must balance its vendor relationships with its own cash flow needs. For the business to develop policies in this area, the finance function must provide information on its cash needs. Holding back on cash outlays as much as possible may seem like a sure solution, but the organization must know whether vendors are charging it higher prices based on that payment history.

- Distinguishing between one-time and recurring costs/expenses. When evaluating and analyzing expenditures, it is important to make a distinction between one-time expenditures of cash versus periodic expenses. Considering one-time or nonrecurring expenditures for things like capital improvements or real estate is different from evaluating and analyzing periodic expenses for payroll and utilities. Periodic expenses are easier to analyze; run rates or percentage analysis can be employed to determine operational trends or anomalies. One-time expenditures, however, are more difficult to put into an analytical context. Contributing to the difficulties of analyzing one-time expenditures is that often these cash outlays do not make it to the P&L but rather get capitalized on the balance sheet and amortized over time. The small and emerging business must understand the difference between these two types of cash outlays and have the capacity to analyze them.

- Classifying operating expenses and cost of sales properly.Analysis in this area will rely on discipline in the finance area. Are expenses being classified properly? For example, classifying an expenditure as cost of sales versus operating expenses may have a huge impact on decision making. How important is managing margins (revenue versus cost of sales)? Do external shareholders have an expectation for the company’s margins? Is certain expense activity related to general business activity (operating expense) or the production of a specific product or service (margin)? Understanding how expenditures will impact the business is the key to decision making. The finance function must be able to interpret data properly and provide input to management to facilitate this kind of decision making.

- Understanding nonoperating expenses. Non-op expenses are those that do not result from day-to-day or recurring business decisions. These are typically items that result from events in the business environment or nonrecurring  business  decisions.  Examples include interest expense or foreign exchange gain/loss from currency fluctuations. The key to managing nonop expenses is knowing the events that give rise to them. Taking on debt, for instance, will require the company to endure the interest expense impact on its financial statements for the life of the loan. This may not be a problem if the company is privately held, but for those that have external reporting requirements it may be an issue. What is the per-share impact of interest expense? How will interest expense impact the statement of cash flows? Regarding foreign currency translation gain/loss, the company must understand that economic events in foreign countries can have a major impact on its financial presentation. Allowing receivables, payables, or debt to remain denominated in foreign currencies may expose the company to potentially radical fluctuations in currencies that are beyond its control. Relying on the finance function to provide input on this matter gives management the ability to fairly evaluate the merits of expanding into overseas markets.