What Exactly Is Revenue? The Case Of The Nigerian Startup Ecosystem

Joel Gascoigne from Buffer recently put up this post apologising for providing a wrong baseline for calculating their annualised revenue estimates. Buffer doesn’t have a CFO from what I gather and I suspect this is rather widespread amongst tech startups considering the immediate focus is to stay afloat.

Key terms like gross versus net revenue, OPEX (operating expense) and cash flow are often given a techie connotation to make it look sexy. I think it’s okay to use terms like how much ‘runway’ (cash) a business has, however founders with non-finance backgrounds must understand the fundamentals of each term used. In fact, a number of these financial metrics remain key indicators akin to symptoms a doctor looks out for before dishing out a prognosis.

Unfortunately, terms used in accounting/finance aren’t necessarily sexy and a number of finance terms make no sense until faced with a real life scenario to actualise them. Suddenly, that “Voilà!” moment happens, when you are able to apply that finance 101 principle and attribute it to real life scenario.

I have observed a key misconception amongst Nigeria’s growing ecosystem as to what revenue is and when to recognise revenue. With regards to what, grey areas are particularly evident in agency relationships (commissions, fees, etc) and in instances where contractual relationships aren’t necessarily clear cut.

Revenue recognition in reality is a job in its own right for larger organisations. This is particularly true where complex financial relationships need to be created for reasons beyond this post.  If you like technical details and long-reads, there is abundance of material on revenue recognition – just Google it.

However if like me you prefer to keep it simple and understand the basics, I will attempt to summarise some of the key principles using some examples.

naira

Example 1

I recently saw this post on Techcabal

The updated Circuitatlantic.com clocked a record $240,000 in sales this January

The quote above suggests gross revenue of $240,000 in January (annualised $2.8m). However, circuitatlantic.com charges a fee of between 5-10%, this would suggest a transaction value $2,400,000 – $4,800,000 in January alone. I doubt that is the case.

From all indications, I would assume this should read transaction value (not sales/revenue) was $240,000 translating in average revenue of between $12,000 and $24,000 (fee income).

While the transaction volume may be useful for internal management reporting/analysis, it should not be convoluted with revenue as it sends the wrong message.

Example 2

If a site acts as a middleman, earns commission or acts as a broker (e.g. a hotels booking site), then revenue (gross) in this case is the fee or commission earned and not the total value of the said transaction. This is true of sites like Hotel.ng and Jovago.com irrespective of who does the payment processing.

There are some exceptions to recognising the full transaction value. However this would depend on a primary test on the merchant versus agency relationship.

Example 3

Payment providers charge fixed and variable fees for services provided (e.g. Paga). Gross revenue in this case is the fee income charged to the merchant/customer and not the total transaction value. Example, looking at Paypal’s 2013 results, transaction volume was $180 billion and actual revenue was $6.6 billion (average 3.6% of transaction value).

Example 4

Marketplaces (e.g. Ebay, Amazon and Konga) are becoming increasingly widespread. The marketplace provider would normally charge a range of fees for services provided to the merchant. Revenue for a marketplace provider would be the various fees and charges and not the total transaction value.

There are exceptions where the marketplace provider may show revenue as gross (total transaction value) but again it would depend on the agreement, risks and rewards.

  • Who is the obligor in the agreement?
  • Who determines pricing?
  • Who holds credit and inventory risk?

Why is this important?

Showing revenue gross or net makes no difference to bottom line results. However where revenue is shown as gross and not net (other than exceptions), this disclosure could give external users a rosier picture than it would seem.

Photo Credit: MTSOfan and André M.Silvestre via Compfight cc

15 Comments

  • Seyi Jill says:

    I guess the writer is @niyoma on Twitter cos I read a version of this post on a blog and i have been trying to find put the real identity of the writer.. Great post.

  • The Taichou says:

    Really great post. I enjoyed it immensely. However, you overlooked goods on consignment which is actually very common in Nigeria. How do you recognise that?

    You state stuff in your post almost like they’re articles of faith. We both know this isn’t the case, ergo, your admission that revenue recognition is a separate job in mid- to large-sized organisations.

    Let’s explore a scenario together: Seller Yousuf has a “Net 60” trade credit arrangement with Trader Okoro. The credit dynamics dictate full invoice amount payable in 60 days. In-built early repayment incentives apply for payment within 30 days (10% discount),or 10 days (20% discount). The order size is N1,000,000.00.

    Best case: Yousef offloads his inventory within a week for N1,050,000.00 and pays Okoro N800,000.00

    Realistic case: Yousef is able to sell off his inventory in a fortnight for N1,100,000.00 and pays Okoro N900,000.00

    Not-so-great case: It takes Yousef 3 months to liquidate his inventory at N1,150,000.00 and he pays Okoro N1,000,000.00.

    What is Yousef’s revenue in each case, and why? Is it computed any differently from Adesuwa’s revenue if we assume that she’s a cash-basis buyer who does the same volume with Okoro? And yes, she gets the full 20% discount. You may disregard nominal amounts and just walk me through your methodology if that helps.

    • niyoma says:

      Thanks, I try and keep it simple and tend to write in 1st person.

      On your question above, this is beyond this post – accrual accounting, cash discounts and cost of sales. Also like to avoid numbers where possible. Anyway if it helps…

      In all 3 cases Okoro will invoice N1,000… Yousef will account for invoice as COS. Settlement discounts have nothing to do with Yousof’s revenue and only impact COS – top-line results. Hence revenue would be what they are – the numbers above

      a. Best case:

      Revenue N1,050
      COS (N1,000)
      ESD 200 << realised via early payment
      ————-
      Gross Profit 250

      b. Realistic case:

      Revenue N1,100
      COS (N1,000)
      ESD 100 <<realised via early payment
      ————-
      Gross Profit 200

      c. Realistic case:

      Revenue N1,150
      COS (N1,000)
      ESD 0 <<realised via early payment
      ————-
      Gross Profit 150

      d. Adesuwa's

      Revenue N1,000 <<assumed
      COS (N800)
      ESD 0 << when realised via early payment
      ————-
      Gross Profit 200

      Main diff in Adewusa – no liability (payable) held on books and 20% is treated as a trade discount not ESD.

      Okoro's revenue on the other hand will be the invoiced amount less ESD.

      COS = cost of sales
      ESD = early settlement discount / purchase discount

    • niyoma says:

      Thanks, I try and keep it simple and tend to write in 1st person.

      For some reason text was all mangled up so attached a screenshot.

      On your question above, this is beyond this post – accrual accounting, cash discounts and cost of sales. Also like to avoid numbers where possible. Anyway if it helps…

      In all 3 cases Okoro will invoice N1,000… Yousef will account for invoice as COS. Settlement discounts have nothing to do with Yousof’s revenue and only impact COS – top-line results. Hence revenue would be what they are – the numbers above

      Main diff in Adewusa – no liability (payable) held on books and 20% is treated as a trade discount not ESD.

      Okoro’s revenue on the other hand will be the invoiced amount less ESD.

      COS = cost of sales
      ESD = early settlement discount / purchase discount

      • The Taichou says:

        Nice one. You do yourself great credit with your prompt responses.

        Just one more thing. How exactly does Yousef’s situation differ materially from Marek’s (or even Mark’s)? Why is it OK for Yousef to recognise the entire sale amount as revenues but our hotels-booking friends only get to show commissions and fees?

        The supermarkets who sell on consignment for bakeries and farms nko? Should they also tease out the [as-yet-unpaid] cost price of the inventory they hold when preparing their books?

        I guess my real question is this:

        “Does the benefit of such granularity in bookkeeping justify the administrative cost?”

        Is this even something we should really be advising early stage startups to focus on? Methinks proper financial education (with respect to fiscal responsibility in cashflow-rich enterprises) and an appreciation of critical financial ratios should suffice. But that’s just my opinion.

        • niyoma says:

          The issue highlighted in the post is around revenue numbers being exaggerated (perhaps unknowingly). Example if a customer books a hotel room for $100. Booking site has an agreement with hotel to receive 20% commission ($20). Hotel holds all the risks, rewards, credit & inventory risk.

          If revenue is shown as gross – the booking site is effect saying

          Revenue (gross) $100
          Payaway (COS) ($80)
          Gross profit $20

          When in fact all it is

          Revenue (commission) $20
          Other costs xxx

          This is not about bookkeeping but about disclosure of the real facts. If the consignor-consignee relationship is commission based then it should be disclosed as such as external users know little about the detail – that’s my point.

          • The Taichou says:

            Noted, thanks.

            By the way, I hope you’ll be one of the mentors available on PushandStart when we launch.

          • Samuel-Biyi 'laolu says:

            niyoma: “Hotel holds all the risks, rewards, credit & inventory risk.’

            I think @TheTaichou:disqus’s concerns are still outstanding. Reality and double-entry accounting does not allow for the simplicity you recommend.

            Let’s add another dimension to this. You create a new product, say, Vouchers, which you sell to people who can redeem for normal products at several merchants. You can either sell these at a premium or a discount, and merchants have no liabilities/rewards until those vouchers are presented to them. Assume a 10% commission/margin negotiated with these merchants. Vouchers never expire.

            Consider this scenario and point out the error in these entries.

            $1,000 Vouchers sold for $1,050 (could be sold for $850 or for at face value of $1,000. Voucher redeemable for products worth $1,000 at several merchants).

            At point of sale (Today):
            Cash= Dr. $1,050
            Revenue= Cr. $50
            Unearned Revenue = Cr. $1,000

            At point of redemption (in 3 months):
            Unearned Revenue: Dr. $1,000
            Revenue: Cr. $1,000
            COS: Dr. $900
            Cash: Cr. $900

            End of accounting period (assuming no OPEX):
            Total Revenue: $1,050
            Total COS: $900
            Ending Cash: $150
            Ending Unearned Revenue: $0

            What happens when you sell the vouchers at a deep discount, sacrificing above the agreed commission? Recognize negative revenue?

            How is the above model different from a Konga selling an event ticket or Hotels selling rights to a room? Why is Konga allowed to recognize revenue for tickets immediately?

            Your method applies only if the buyer buys the vouchers at the merchants’ counter, and you expect the merchant to settle you. Then you can record Cash/Accts Receivable and Revenue directly as the commission amount.

            Fundamentally, however you look at the main scenario above, $1,000 worth of vouchers have been sold for $1,050. $1,000 in the bank is really for no one, but it’s under your administration. The merchants have no obligation until someone comes over to them to redeem–could be tomorrow, could be in a year. Within that year, commissions can be renegotiated from 10% to 15%. Voucher holder can elect to exchange a Merchant A voucher for a Merchant B voucher. Maybe buyer can request a refund from you, maybe not, and you need to do your reports.

            Like call options, you have sold the “rights” to make a purchase at any of the merchants, not any actual product or service from the merchant. Likewise, a bookings site has sold rights to the room/sit, not the actual room. At some point, liability rests with the bookings site. The bookings site is either obligated to the customer, or to the hotel, until the holder of the ‘rights’ ultimately redeems, and you settle the merchant based on understanding.

            Broadly, only the timing of the liability transfer separates all the businesses above from each other. It will be painful accounting to recognize revenue only when you settle your merchants, and it’s pretty much going back to cash-based accounting. I don’t think a hard rule can be applied to revenue recognition across board.

            In general, I think these are the only rules that can be imposed:

            –Do not record transactions as revenue; record transaction fees.
            –If you’re an intermediary, you may or may not record total sales as revenue, depending on your personal circumstances.

            In reality, a hybrid of your method and the one suggested above can be applied. The key is distinguishing Unearned Revenue (Liability) from Revenue, but if you asked me, unearned revenue is as good as revenue if you will earn it with 100% certainty– in the case of the vouchers, an automatic transfer of liability at T + X.

          • The Taichou says:

            And now, my accounting geeks have come out to play!

            @samuelbiyilaolu:disqus, your comment is awesome on many levels. It uses what I suspect is a real-life scenario, and it highlights a key difference between theory and practice. I guess that’s why before the advent of IFRS, accounting standards only needed to be “generally accepted” and not “best practice”. Viewer discretion is advised.

            Now, let me grab my jotter and take a back seat.

          • niyoma says:

            You seem to be talking about deferred income really. You may want to read on how the likes of Expedia, Amazon and co recognise income. There are FRS/GAAPs that provide guidance on this. If the booking site holds the risk and rewards fine – scope to show gross. For example if the booking site prepays or has an agreement to allocate x number of rooms irrespective of being booked or not then yes there is scope since there is clearly inventory risk here. If it is commission the that’s what it is.

            Would appear you have a finance background. If you like long reads have a look at EITF Issue No. 99-19, Reporting Revenue Gross as a Principal Versus Net as an Agent. This was just after the dotcom boom. Also have a look at the relevant IAS/GAAPs.

            http://www.fasb.org/cs/BlobServer?blobcol=urldata&blobtable=MungoBlobs&blobkey=id&blobwhere=1175820914023&blobheader=application/pdf

          • Samuel-Biyi 'laolu says:

            Will study. Cheers.

          • Samuel-Biyi 'laolu says:

            Done. Enjoyed reading the 13 examples. You see, unless one can get as much information about a specific business as you have in those examples, one cannot allocate ‘qualitative weightings’ to arrive at a gross/net revenue reporting evaluation. We can only hope that when businesses here quote gross revenue, their circumstances will support them when exposed.

            At the moment, gross revenue figures are doing a fine job ‘gingering’ the infamous ‘ecosystem’ :).

          • michino says:

            On point with your explanation

  • well I think the message the writer is trying to pass across is that when gross and net revenues are not explicitly stated, there is a tendency that outsiders will miss-conceive the truth and in other cases even the start-up in itself can make decision that can affect them adversely if they don’t understand the difference that will be spending or budgeting for the money they don’t have.

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