As tax day approaches here in the United States, it is as good a time as any to highlight an important financial issue that many agency owners get wrong.
You should probably be keeping two sets of books.
No, I’m not talking about the way that an organized crime boss might do it to evade prosecution. I’m talking about a completely legal approach to understanding how your business is performing while still maximizing the tax benefits that you receive as a business owner.
Most PR and marketing agencies operate on what is known as cash basis accounting. It’s pretty similar to how most people manage their household finances.
With cash accounting, when you get paid by a client and deposit the check, you record the revenue in full. When you pay a bill, you show that expense in its entirety in the same month and year.
For tax purposes, this is often beneficial. It’s why your accountant may encourage you to accelerate purchases at the end of a good year to minimize your tax burden. Some of you have no doubt experienced the opposite end of this as clients try to clear cash from their own books in December.
While cash accounting is simple and well-suited to tax needs, it isn’t a great way to judge the overall financial health and business performance of your agency. It is one of the reasons why your monthly financials end up looking like a roller-coaster even if you haven’t had any changes in clients or staffing.
While cash accounting works well for managing your tax burden, accrual accounting is a better way to analyze the progress that your agency business is making.
With accrual accounting, you show revenue as occurring in the month that the work was performed. Similarly, expenses show up for the month in which the service or product was received.
For example, if you do $5000 worth of work for Acme Industries in March, but they don’t pay you until May, it shows up in March with accrual accounting, but not until May on a cash basis. When Acme lumps in their April invoice with that May payment, you will now see a big increase in revenue on a cash basis in May – but it doesn’t mean that the business is actually growing.
In this way, accrual accounting smooths out the peaks and valleys of revenue and expenses that occur when you track cash in and out in real-time. It provides a more accurate picture of the trends in your business.
Getting the insights you need from your finances
A good bookkeeping and accounting team can help deliver the information you need while still enabling you to manage your tax impact effectively.
It requires a little more data entry effort upfront, but producing cash and accrual reports from most financial software used by small businesses is a pretty trivial task.
Even if you and your team aren’t set up for it now, you probably have few enough revenue sources that you can – at a minimum – track that independently. If most of your clients are billed monthly for the work that you do, your invoices can help paint this picture. If you do project work that doesn’t match up to invoice periods or you have clients who prepay for service, then you may need to keep a separate spreadsheet until your bookkeeping and accounting team can take the steps needed to routinely provide you the right reports.
The information matters more than the terminology
I’m sure that many of you have had your eyes glaze over reading about cash and accrual accounting and just want this article to end.
I know that most PR and marketing agency owners didn’t start their businesses to dig deep into the numbers. But that doesn’t eliminate the need to understand the fundamentals of your business finances in order to make better decisions.
So don’t get hung up on cash or accrual accounting, and instead have a conversation with your bookkeeper and/or accountant to figure out how they can give you information that meets both your tax and business management needs.
Once you start looking at your numbers without the distortion that cash accounting provides, you will be better informed and won’t ride too high when an extra check gets deposited in April – or feel too low when May is a bit lighter on deposits as a result.