The month that looks bad for no reason
January's profit is noticeably lower, and nothing operational went wrong in January. A software supplier's bill for 24,000 arrived, covering a subscription from January to December, and somebody recorded the whole of it as a January expense. January carries 22,000 of cost that belongs to the other eleven months, and each of those months looks 2,000 cheaper than it was. Then March moves in the opposite direction: a consultant's retainer costs 5,000 a month, the March bill has not arrived yet, and March shows no expense for it at all.
The revenue side of this story has its own article, on why what you invoiced is not what you earned. This article is the mirror image on the expense side, written for the same reader. What a supplier bills you is not what you have used up, and a month with no bill is not a free month.
Billed to you is not used up
Consider the software subscription: on 8 January the supplier bills you 24,000 for a subscription that runs from January to December. Billed to you: 24,000. That figure is a fact, and the supplier's bill is the document that establishes it.
But by the end of March you have used only three months of the subscription. Used up: 6,000. The remaining 18,000 is paid ahead: you have been billed for it, and you may already have paid it, but the service is still to be delivered. Accountants call an amount paid ahead a prepaid, the first of two accounting words in this article.
Here is the same bill as three lines at the end of March:
- Billed to you: 24,000
- Used up: 6,000
- Paid ahead: 18,000
The 18,000 is not an expense yet, whatever the bill's date suggests. It appears on the balance sheet as an amount the supplier still owes you in service, and it becomes an expense one month at a time as the subscription is delivered.
A month with no bill is not a free month
Now consider the consultant's retainer, agreed at 5,000 a month: the March bill has not arrived, and so nobody has recorded a March expense. But you received the consultant's time in March, and March's expense is 5,000 regardless of whether the paperwork has arrived.
The entry that puts it there is called an accrual, the second accounting word in this article. It records the expense in the period the service was received, regardless of when the bill arrives. Without it, March appears 5,000 better than it really was, and April, when two bills arrive together, appears 5,000 worse.
Why a board should care
A board reads the P&L month by month, and it reads the margin percentage. A year's expense landing in one month makes that month look poor and the other eleven look generous, and a missing month makes a quarter look better than it was. Neither reflects a genuine change in the business; both are the timing of the supplier's paperwork, and both distort every comparison the board is shown.
The distortion reaches beyond the board pack. A lender's covenant tested on a quarter's profit moves with the bill date rather than with the service, and a comparison to the previous year breaks when the previous year's bill arrived in a different month. An auditor will request the schedule of amounts paid ahead and the schedule of expenses not yet billed, because both appear on every audit programme, and an acquirer's accountant will recompute the margin with both corrected before deciding what the business is worth.
The checks that catch it
Ressura tests this bill by bill, in the Procure-to-Pay module, against the agreement behind each supplier. Used up against billed compares what a bill charged you with what you should have used up by the end of the period, given the months the agreement says the bill pays for. A year's bill recorded in a single month appears here, together with the months it overstates.
Paid ahead reports what is still to be delivered at the end of the period, bill by bill, with the agreement and the bill behind each number. Missing accrual covers the opposite case: a fee the agreement obliges you to pay every month, with no bill in the period; the finding identifies the agreement, the month and the amount that should have been recorded.
Three checks, and every expense attributed to the month it belongs to. Read what Procure-to-Pay checks.