Leave cash on the table - Do your agency finances need to grow up?

When an agency is first founded, the finances are often handled in the simplest of ways, with the current bank balance being the main metric monitored. The founder knows they’re making money if the bank balance is growing, and knows they aren’t if it shrinks.. Cash accounting, as your accountant will call this approach, is simple, effective and seems to make perfect sense. Unfortunately, as your agency grows and becomes more complex, cash accounting quickly falls behind the needs of the business and can lead to a dangerous false sense of security.

The limitations of cash accounting often become clear to founders in painful ways. For me, it was a large VAT bill sometime in the late ’90s that left us struggling to make payroll to complete work we had already been paid for. We’d been landing bigger projects, the bank balance looked healthy, but deposit payments had masked the fact that we were not operating profitably, and everything got rather stressful for a while – especially when the late VAT payment triggered 3 days of VAT inspection.

This mistake feels naive with a few decades of hindsight, but is a pattern I see often. It often takes a situation like this to realise that the business has outgrown cash accounting, but it shouldn’t. This is a predictable path that businesses (and their advisors) should be ahead of. In the simplest of terms, cash accounting will usually reach the end of its useful life as more of the following become factors for the business:

• Registering for VAT: When we start collecting VAT on sales our bank balances include money that is owed to HMRC. The relationship between cash and profit becomes looser and bank balances become a less reliable indicator.
• Employees on Payroll: Employing people creates new liabilities that will not show in cash balances. By the time we near month end there can be significant sums owed in terms of Salaries, National Insurance, PAYE, Pension contributions and other benefits. Cash accounting might not provide a clear picture of these costs.
• Larger Tax Liabilities: Higher profits often mean increased corporation tax. Cash accounting can distort your profit picture, leading to unexpected tax bills.
• Investing in Assets: Significant purchases of equipment or other assets require depreciation, which is not accounted for under cash accounting.
• Complex Projects: Long-term projects with staged payments or deliverables demand more sophisticated financial tracking than cash accounting allows.
• Seeking Finance or Investment: Investors and lenders typically expect businesses to use accrual accounting as it provides a more accurate representation of financial performance.

Switching from cash accounting to the alternative of accrual accounting can make sense when any of the above triggers occurs, but makes increasingly more sense as more of those triggers come into play.

Accrual accounting explained in simple terms

Let’s start by demystifying the term “accrual accounting”: Lots of small business owners shut off when they hear terms like this, assuming they are more complex than they are. Like almost every industry, accounting and finance love to use fancy terms to describe simple things. Accrual accounting is simply the process of recording income and expenditure when they occur, rather than when the money actually moved. Here is a simple example:

The worked example makes the difference clear: Cash accounting records transactions based on when cash moves, where accrual accounting records them when they are earned or incurred. The advantage is that we get a more accurate picture of profitability per period.

Making the switch

Accrual Accounting is very much the norm in business, with the smallest businesses being those most likely to stick with cash accounting. Cash accounting does involve less bookkeeping, so will save direct costs, but the advantage of having a more accurate picture of the business performance will outweigh this for most. In short, the question for many will be “when to make the change” rather than “if to”. 

I’ve explained the underlying principle of accrual accounting is recording transactions on the date they occur economically, not when cash changes hands. Let’s look in detail at both expenditure and revenue to see how that actually works in practice:

Expenditure

When recording expenses, the golden rule is to match the cost to the period in which it provides value to your business. Here are some common scenarios:

1. One-off purchases: Record these on the invoice date, not the payment date. For example, if you buy office supplies on 28th March but pay for them on 5th April, you’d record the expense in March.
2. Recurring services: For services like hosting, spread the cost over the period it covers. If you pay £1,200 for a year’s hosting on 1st January, you’d recognise £100 as an expense each month throughout the year.
3. Staff costs: Record salaries in the month employees earn them, even if you pay in arrears. Include any accrued holiday pay.
4. Prepayments: If you pay for something in advance, only recognise the portion that relates to the current period as an expense. The rest becomes a prepayment asset on your balance sheet.

Revenue

Recognising revenue can be trickier, especially for agencies with long-term projects. Here are some guidelines:

1. Time and materials projects: Recognise revenue as you complete the work, typically monthly. If you’ve worked but not yet invoiced, record the world in progress as accrued income.
2. Fixed price projects: Recognise revenue using methods like the Percentage of Completion or Milestone-based approaches to accurately reflect the work completed.
3. Retainers: Recognise revenue evenly across the retainer period, regardless of when you invoice or receive payment.
4. Deposits: Don’t recognise these as revenue immediately. Instead, record them as a liability (customer deposit) until you’ve earned them by doing the work.

If all of this is starting to make your head hurt, then talk to your bookkeeper. This is bread and butter for them and it is simple once you have the process in place (and if you don’t have a bookkeeper get one – it is the first thing most people should outsource).

Why bother? 

At this point, you might be wondering if all this effort is really worth it. I promise that it is. Accrual accounting isn’t just a fancy way to complicate your bookkeeping – it’s a powerful tool that is an absolute necessity to run a growing business well. Here’s why:

1. Clarity: You’ll get a crystal-clear picture of your agency’s financial health at any given moment. No more nasty surprises like that VAT bill that caught me out in the ’90s.
2. Better decision making: With accurate, up-to-date financial information, you can make informed decisions about hiring, taking on new projects, or investing in growth.
3. Attracting investment: If you’re looking to secure funding or sell your agency down the line, accrual accounting is essential. It’s what serious investors expect to see.
4. Scalability: As your agency grows, accrual accounting grows with you. It’s the foundation for more sophisticated financial management and reporting.
5. Profitability insights: You’ll be able to see which projects, clients, or services are truly profitable – not just which ones bring in the most cash.
6. Tax Efficiency : The timing of profit recognition can help smooth out profitability and therefore dividends

The switch to accrual accounting might seem daunting at first, but it’s a rite of passage for growing agencies. Don’t wait for a crisis to force your hand. If you’re hitting any of the triggers we discussed earlier – VAT registration, growing payroll, bigger projects – it’s time to make the leap. Talk to your accountant or bookkeeper about making the switch. They’ll be able to guide you through the process and set up systems that make it manageable.

Remember, your agency’s finances are too important to be left to guesswork or gut feeling. Accrual accounting gives you the tools to truly understand your business’s financial story – and to write the next chapters with confidence. If you have passed any of the triggers discussed at the start of this article and are stil using cash accounting it is probably time to have this conversation with your FD, Accountant or Advisor.