Using Deferred Revenue to Balance Your Books

 

Delaying Revenue Recording

One of the biggest factors distorting profitability reporting for agencies is improper revenue recognition. Many agencies bill clients upfront for work and record that income immediately upon invoicing rather than aligning the revenue to the period when work is actually performed. This cash-basis approach goes against accrual accounting principles and skews agency profit metrics.

A common scenario is where an agency invoices a client 50% upfront for a project and the remaining 50% upon completion. If the agency records the full 100% upfront invoice amount as revenue right away, their profit for that period will be significantly overstated. Any costs involved in delivering the work over future periods are not appropriately matched against the real timing of revenue being earned.

 

How to Handle Invoicing

So how should agencies handle invoicing and income recording to get an accurate read on profitability over time? 

The accrual accounting approach follows the income recognition principle — revenue should only be recorded when it is earned and the related work has been delivered to the customer.

Using the agency’s standard invoicing process is perfectly fine. The key is adjusting where those upfront amounts get recorded upon initial billing and payment. Rather than immediately hitting revenue accounts on the income statement, these upfront billings get booked as deferred revenue, which is a liability account on the balance sheet.

 

Deferred Revenue Principles

Deferred revenue represents cash received for work not yet performed. It is an obligation of future services to be rendered. As that work is completed and costs are appropriately incurred over time, portions of the deferred revenue balance are then transferred into revenue accounts on the income statement through adjusting journal entries.

“We would record the invoice like we usually record any invoice, and then we’ll use journal entries to recognize that revenue in January, February, March, etc. as the services are being rendered,” says Sara Snyder. For example, if upfront billings cover five months of work at $4,000 per month, the agency would record $4,000 of revenue each month via journal entry while relieving the deferred revenue balance.

This accrual methodology applies whether the project income is recorded as a lump sum upon completion, or divided up each month. The key is keeping invoiced amounts in deferred revenue until the work is done and offsetting costs are incurred.

 

Journaling Income in QuickBooks

To simplify the tracking of deferred revenue balances and schedules for recognizing revenue over time, accounting systems like QuickBooks allow for recurring journal entries. These automated entries take the friction out of the process for most agencies with standardized billing cycles and retainer fees.

While more tedious than cash basis accounting, the extra work is worthwhile to gain an accurate picture of the agency’s monthly profitability. This provides the insights needed to properly manage the business, staffing levels, pricing, and other key operational metrics that depend on reliable profit data.

 

Leaning on Your Accountant

Many agencies turn to their accountants to help implement these proper accrual processes. Accountants can review the specifics of the agency’s client billing arrangements and work delivery schedules to develop the appropriate deferred revenue tracking and revenue recognition schedules.

They can set up the necessary accounts in the agency’s accounting system, configure recurring journal entries to automate the monthly recognition cycles, and ensure income and expenses get properly matched. This frees up agency leadership to just focus on monitoring accurate profit metrics each month for decision making.

Accountants also provide continuity and consistency in applying these accrual practices over time. As an outside resource, they can objectively review and adjust processes as needed if billing arrangements or client agreements evolve. This safeguards against improper ad-hoc recording that can quickly distort agency financial reporting.

 

In Conclusion

Accurate accrual-based profit reporting is critical for agency financial management and growth. By working closely with their accountants, agencies can implement best practices for revenue recognition tied to their unique billing processes and cycles. The result is a clear, reliable view of profitability to optimally run and scale their businesses.

To discover more about how agencies can improve their financial statements and revenue outlook, tune in to this episode of The Progressive Agency Podcast to hear more from our guest, Sara Snyder.