Income Received in Advance: It’s a Probity Test
This is a general guide to post-pandemic balance sheet management.
The greatest test on the probity of a business manager is income received in advance. This is also known as unearned revenue. A common accounting term is a prepaid income. I prefer using the long phrase “income received in advance” because it is more descriptive.
How a business handled Income Received in Advance (IRIA) before the pandemic has been a key determinant of business success during the pandemic and will be key in the post-pandemic business environment.
Examples of Businesses that face the IRIA test
- Tourism companies (travel agents, tour operators, safaris).
- Travel companies (airlines, tours & transfers, etc)
- Businesses that levy an annual subscription — Software and magazines, etc.
- Construction companies that receive a deposit before commencing work.
Test of Probity
Probity refers to the quality of having strong moral principles such as honesty, integrity, and decency. As a business manager overseeing the affairs of a business that receives income in advance, you are to show probity in the management of the business by not chopping income received in advance.
Clients pay you before you render a service or deliver goods. Even though the funds are already in your bank account, you have not yet earned them. You only earn them when you have performed the service or delivered on the deliverables.
Chowing money that you have not yet earned shows a lack of probity. It shows that the business cannot be trusted with clients' funds. A business that receives income in advance is faced with this test of probity. Failing to show probity can harm both clients and the business.
Handling IRIA is at the core of balance sheet management for companies that receive such income. Many businesses have failed because of a failure to manage IRIA. Owner-managed businesses are notorious for mismanaging IRIA.
A wedding planner receives a bulk payment of $100,000 to pay for wedding expenses, 6 months ahead of the wedding. He/she pays deposits to suppliers and starts chowing the rest as if he or she has already earned that income, relying on future cash inflows from other clients to cover the hole created today.
A travel company sells safaris where clients pay 30 to 90 days before the trip. The balance sheet shows IRIA of $10m, suppliers paid in advance show a balance of $2m whilst the bank account shows a balance of $2m. Where did the other $6m received from clients go? It was chowed by the business.
Now the business relies on clients making bookings today to cover the expenses of clients traveling today. Peter’s future booking is paying Paul’s current trip expenses.
The typical story is that of an entity that uses IRIA as funding for the purchase of long-term assets. The worst case is when the owner-manager purchases a luxurious vehicle.
It is very common in corruption-ridden developing countries where connected tenderpreneurs feed on the economic corpus like a pack of hyenas. They get the contract, they are paid a deposit, they chow the deposit and close off the business.
They never get to receive the balance because the intention was never to deliver on the deliverables. These fellas are not really businesspersons, they are thieves, so they can be excused for total lack of probity. A proper business manager, however, has to show probity in handling IRIA because it affects the going concern of the business.
It's a Trap- A Blessing and a Curse
It is a business model blessing to get paid in advance because it takes away the hassle of handling debtors. It takes away the cash flow problem of having to finance a transaction yourself. The client funds the transaction. It is only a blessing if managed well. If not managed well, it turns into a curse.
IRIA is a temptation. It is a temptation that the business manager has to overcome. The money is there in the bank account. The service is going to be performed in the future. The money begs to be spent now. It swells up the bank balances and whispers in the ear of the business manager, “Please spend me”.
Chowing IRIA is digging a hole. A hole that needs to be filled later. It’s a trap. You set the trap your own self. Once you start digging that hole, there is no end. You dig a little, and you get away with it because inflows keep you afloat. There are no ramifications.
You dig more and nothing happens, business continues as usual. Sooner or later, there is another urgent need (this sure-fire business opportunity, this high positive NPV project, this chance to expand operations, etc)for you to dig into IRIA. It becomes a habit. You dig into that pot, and nothing happens.
One day, the hole becomes too large. The hole that was minor all along becomes too large hastily. It swallows both the business manager and the business. The rot occurs gradually then suddenly. Gradually, the hole grows in size. Suddenly, it becomes too large to be temporarily covered by currently incoming receipts.
That is how you get trapped, gradually then suddenly. You don't realize you are being trapped into business failure because the cash flow does not show any early signs. Signs only pop up when it's too late.
The business that does not receive income in advance gets plenty of signals before it's too late. They don’t get the chance to dig a very big hole that they cannot escape from, because there is nobody who gives them such funds. They can only dig into cash flow generated from operations, which is too sensitive and gives early signals.
Monitoring the IRIA
At any given point in time, the business manager must know the size of the IRIA liability. He or she should have a very close approximation of that liability. It is a very important figure for a business that gets IRIA. It is typically the largest or second-largest figure on the balance sheet.
This brings us to the matter of accounting. Accountants can be lazy. IRIA should be a standalone figure in the balance sheet. Oftentimes, the receipts are applied to customer accounts or are attached to future dated invoices, depending on the accounting system in use.
This results in those balances being presented as negative balances on the customer control account. This leads to confusion, especially if the business has other revenue lines where it invoices in arrears (i.e., the opposite of Income received in Advance).
In these instances, the positive balances for invoices due for payment (where services have been rendered already and invoices have been raised) counters and dilutes the IRIA (where services will only be rendered in the future).
The result is either a negative customer account balance or a low positive customer control account balance. The resulting figure is misleading to the business manager. The manager does not know how to interpret it, other than the fact that it's a net exposure, a mixture of assets and liabilities.
IRIA should go to a separate balance sheet account as a liability. It can be removed and allocated to a customer invoice or a customer GL, in the month that the invoice is raised. This manner of bookkeeping allows the business manager to monitor IRIA.
Monitoring should be done within the context of bank balances. Viewing the sheer size of the liability outside the context of the bank balance does not provide value. In this regard, I encourage the usage of two ratios that I refer to as Cover ratios.
This is borrowed from the Cash Cover term in trade financing. They are not the same thing, but I just name it a cash cover because that is the most intuitive thing to say.
Two Useful ratios:
- Cash Cover Ratio = Bank Balance / IRIA
- Liquid Cover Ratio = (Bank Balances + Suppliers paid in advance) / IRIA
The Cash Cover Ratio is pure. It is an indicator of the company's ability to meet refunds, should any arise. It answers the hypothetical question that if we were told to stop trading today, would we be able to meet this liability known as income received in advance?
The liquid cover is gauging the financial resources you have available to meet the IRIA liability. The liquid cover builds from the cash cover by adding suppliers that we have paid in advance.
It is the most sensible thing to do. Although the company received $100 in advance from a client, the company has also paid $40 to suppliers who are going to help in providing the service in the future. Suppliers paid in advance are also a balance sheet item. It is a financial resource because, in case of a cancellation, the business can typically request a refund from the supplier and use the funds to pay back the client.
The liquid cover ratio totally ignores illiquid resources such as fixed assets (property, vehicles, software, and loans to other businesses), even though these are items that can be liquidated for cash.
Ideally, the Liquid cover ratio should be above 100%, because bank balances typically include profit earned from prior periods.
The reality is that it is never 100% for most businesses, even if the bank balances include receipts from a loan or from a capital injection. This shows how badly most businesses that get IRIA are managed.
Any ratio below 100% reveals a hole. It is a funding gap.
Threat of regulation
The size of holes of this nature that exists in many corporations (large and small) was exposed by the pandemic. The threat of regulation was looming before the pandemic. Post pandemic, regulation is an eventuality for most jurisdictions.
Airlines, hotels, and other companies in travel, tourism, and hospitality failed to honor refunds. Software businesses where clients canceled on annual subscriptions halfway through the year failed to honor refund claims for the balance of the year.
In order to protect customers, action groups are calling for regulation to establish escrow accounts where clients can pay funds, and the service provider can only receive the funds after performing the service. This would affect all other suppliers down the value chain.
A different form of self-regulation could exist where businesses that receive income in advance are forced to have a liquid cover ratio above 100%. This is something that I would push for instead of escrow accounts and trustee accounts.
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