Most agencies use the the accrual basis method of accounting because it aligns more closely with how our businesses actually run and gives the agency owner more realistic numbers and metrics, so their decisions are better informed throughout the year.
In the cash method of accounting – the day a business gets a check or cash from the client, it recognizes the revenue. This works well in a retail world. I walk into the grocery store. I pick up milk and bread and give the cashier some money. At that point, they have actually earned that money. Our transaction is complete.
But in our world – in many cases, when a client gives us money, we haven’t actually earned that money. If the client asked for the retainer or the media pre-payment back, we have to return the money because it’s not ours yet. We haven’t done the work.
But in the accrual model of accounting, transactions are accounted for when the transaction occurs or is earned, regardless of when the cash is paid or received. (Note: most agencies convert to cash for tax purposes.)
Let’s play this out. You send a client an invoice for $30,000 which is 50% of a project’s fee, after they sign the scope of work. They send you a check. Your bookkeeper should book that $30,000 as a liability. Again – if they ask for the money back the next day, you owe them the $30,000.
If your bookkeeper books that as a sale or revenue (like they would in the cash method) it would tell a lie. It would say that you did $30,000 worth of work in that month and you can spend that money without risk or consequence. In reality, you haven’t done any of the work yet and it’s not yours to spend. (Although few agencies actually put that money aside – they take the risk of spending the money now and if the client asks for a refund – the agency will scramble to pull the money together.)
But if you’re doing it properly, the $30,000 is recorded as a liability and your agency works against that liability. Let me sketch out how this works.
January: Send client invoice for $30K and the client pays it. Your bookkeeper records it as a liability. No work is done on this project in January so all $30K remains a liability.
February: Your team does $7,000 worth of work on that project and spent $5K in hard costs, like media or video production with an outside firm. Your bookkeeper would create an invoice in your accounting software for $12,000 and transfers $12,000 from the liability G/L and moves it into the gross revenue G/L because that’s how much you actually earned this month. You still have $18K in liability to the client. You may or may not send the invoice to the client. But you definitely want to create it in your system so you can track how and when the money was earned.
March: Your team does another $5K of work. Again, your bookkeeper would create an invoice in your accounting software for $5,000 and transfers $5,000 from the liability G/L and moves it into the gross revenue G/L because that’s how much you actually earned this month. You still have $13K in liability to the client.
April: Your team delivers a key milestone in the project, which the scope of work says triggers an additional $15,000 invoice. They actually did $18K of work. Your bookkeeper would create two invoices in your accounting software. The first invoice for $15,000 for the milestone billing. The client sends a check. That $15,000 is put into the liability G/L.
The second one should be for $18,000 and transfers $18,000 from the liability G/L and moves it into the gross revenue G/L because that’s how much you actually earned this month.
You had $5K in the liability G/L before this month. We added $15K with the milestone bill. So, the new total liability is $20K. But the $18K invoice reduces that to $2K of liability. At this point you have actually earned $43K of the $45K you have billed to date.
May: Your team wraps up the project and delivers it successfully. They did $14,000 worth of work to complete the project. According to the scope of work, that triggers the final invoice of $15,000.
Your bookkeeper would create two invoices in your accounting software. The first invoice for $15,000 for the final milestone billing. The client sends a check. That $15,000 is put into the liability G/L.
The second Invoice should be for $14,000 worth of work and $3K worth of pure profit because you estimated well, so a total of $17,000. (Of course, if you actually send this invoice to the client, you wouldn’t word it that way) and transfers the final $17,000 from the liability G/L and moves it into the gross revenue G/L because that’s how much you actually earned as you wrapped up this project.
Here’s what you accomplished by handling the billing this way.
- You know exactly when they money was earned.
- You always knew what you were on the hook for, if the client called and said they wanted to cancel the project.
- You have an accurate understanding of how you used your people resources throughout the project and the money implications of that.
- You know how profitable to job was because you were tracking it against actual work done/hard costs incurred.
- This information helps you structure proposals and timelines in the future. It might tell you to move the milestones so you get more money upfront or some other tweak.
Because the accrual basis of accounting requires you to report income when the business earns it rather than when paid, your accounting financials reflect the actual month when sales occurred. It’s a genuine reflection of what really happened.
Sometimes to simplify the process for a client we do a pro-rated write-off of the liability if we can reasonably estimate the time to complete the project. For example, a $50,000 website is expected to take 5 months with generally consistent amounts of people time each month we just recognize 10k per month in revenue and use the client prepaid liability to true-up based on if the client is prepaying or not.
A couple other benefits to the accrual method of accounting:
- For large expenses paid in advance, such as liability and property insurance, the accrual basis of accounting allows you to expense the payment proportionately according to the number of months the payment covers. For example, if you pay $6,000 for annual property insurance coverage in January, you expense $500 each month for 12 months rather than recording the entire $6,000 of expense in January when you issue the check.
- The accrual basis of accounting also allows you to expense large items that cover several months and the business pays in arrears, such as real estate tax. These are allocations before payment referred to as “accrued expenses.” If you will owe $12,000 in real estate tax payable at the end of the year, you can expense $1,000 a month on your accounting general ledger to spread the cost evenly across the year.
By the way, you may not have a choice.
The new tax law allows accrual basis for organization with cash receipts of less than 25 million (https://www.irs.gov/newsroom/irs-issues-guidance-on-small-business-accounting-method-changes-under-tax-cuts-and-jobs-act). This mostly benefits organizations that have inventory but if an agency is on accrual from the past it may make sense to switch to cash for tax purposes this year.
Whether you are required to do it or not, it is definitely a best practice for agencies, big or small. By converting to a cash basis for taxes, you can enjoy the best of both accounting methods while still having accurate data about cash flow, earnings, and resource demands.