Accounting for Residential Maintenance Agreements
Originally published: 02.01.13 by Ruth King
Don’t post the revenues incorrectly, or you’ll end up with ‘financial fruit salad.’
Editor’s Note: This is the first in a three-part series on accounting for maintenance agreements. In the March column, Ruth addressed accounting for commercial maintenance agreements; and in April, she’ll address tracking of the value of maintenance agreements.
A good maintenance agreement program will help even out cash flow, increase your company’s bottom line, and keep your field employees productive throughout the year.
Properly tracking and accounting for these agreements is critical to the success of your maintenance program.
First, accounting for residential agreements (commercial accounting will be covered in the next column): Whether you collect the entire year’s payment up front or you collect 1/12th of the payment each month through monthly recurring billing, the dollars you collect are not yours until you perform the maintenance checks. This is the biggest mistake contractors make when accounting for residential maintenance agreements. The dollars you collect are a liability to your company — you have an obligation to perform the work. Your customer paid you on a bet and the faith that you will perform the work she is paying for in advance.
The money you receive should go into an interest-bearing
When you receive the maintenance agreement dollars, they are accounted for in a balance sheet current-liability account called deferred income.
Let’s assume that Mrs. Jones paid you $180 for the year. When you receive her payment the transaction is:
• Credit: Deferred Income — Maintenance Agreements for $180
• Debit: Cash — Savings Accounts for $180
Notice that when you receive the money, you do not have a sale. You get a sale when you perform the work.
Next, your technician performs the first maintenance check. The accounting transaction is:
• Debit: Deferred Income — Maintenance Agreements for $90 (balance in the account is $90)
• Credit: Sales — Maintenance Agreements for $90
You have decreased your liability to perform by $90, and you’ve increased sales by $90. Then, the cost to perform that work is taken out of the $90 in revenues you received. Hopefully you’ve at least broken even on the performance of that maintenance agreement.
Next, your technician performs the second maintenance check. The accounting transaction is:
• Debit: Deferred Income — Maintenance Agreements for $90 (balance in the account is $0)
• Credit: Sales — Maintenance Agreements for $90
You have no more liability to perform. You’ve provided Mrs. Jones everything that you promised. You have the total sale of $180 and $0 deferred income.
What happens to the cash when you perform the work? If you need the $90 to cover expenses, you can take it out of your savings account and put it in your operations account. My experience is that most contractors don’t need the cash (or at least all the cash), and the dollars go in your interest-bearing savings account that is accumulating to provide your company with a cash safety net.
What happens if you record the sale when you enroll Mrs. Jones as a maintenance agreement customer? You have what I call “financial statement fruit salad.” This happens when revenues are in one month (apples) and expenses incurred producing those revenues are in another month (oranges). Matching those revenues and expenses is fruit salad — you are comparing apples and oranges, i.e., fruit salad. You do not want fruit salad. You want apple salad or orange salad.
Here’s why: Your margins will not be consistent, and you won’t know whether you are at least breaking even on your maintenance agreement sales.
Here’s an example to illustrate this point:
Mrs. Jones paid you in January for her maintenance agreement: and,
• you accounted for that maintenance agreement as a January sale;
• you perform the first check in April; then,
• you perform the second check in October.
In January you have revenue with no matching expenses. In April and October, you have expenses with no offsetting revenue. In all three months you have financial statement fruit salad. January’s profit-and-loss statement will look better than it should (higher profits because there are revenues and no expenses incurred in producing those revenues). April and October’s profit-and-loss statements will look worse than they should (lower profits because there are expenses and no revenues to offset those expenses).
Make sure that you have a deferred-income account and a savings account on your balance sheet. Then, record the sale and performance of your maintenance agreements accurately. You’ll know that your profit-and-loss statements are accurate, and you can see whether you are breaking even or profiting from your maintenance agreement sales.
Ruth King has over 25 years of experience in the hvacr industry and has worked with contractors, distributors, and manufacturers to help grow their companies and to become more profitable. She is president of HVAC Channel TV and holds a Class ll (unrestricted) contractors license in Georgia. Ruth has authored two books: The Ugly Truth about Small Business and The Ugly Truth about Managing People. Contact Ruth at firstname.lastname@example.org or 770-729-0258.
Articles by Ruth King
Understand Your P&L Statement: Gross Margin, pt. 2
Gross margin should not vary more than a few points each month. If it does, then you must find out why the margin is varying.
Understand Your P&L Statement: Gross Margin
Understand Your P&L Statement: Cost of Goods Sold
However you decide to categorize expenses in your P&L, it's important to be consistent.
Understand Your P&L Statement: Sales vs. Revenue
Sales are critical to survival — when revenue is actually generated is even more critical.
The 20 Percent Profit Myth
For a realistic goal, include owners’ compensation in the net profit equation.