I’m sure there are plenty of other captivating problems to tackle in your agency rather than getting lost in your financials.
But, as an agency owner, you really must understand basic financial accounting and how it applies to your business if you want a well-rounded view of your agency’s financial health.
At this point, you may be wondering what financial accounting is and how it differs from the other types of accounting.
Or, I may have already lost you to the cat video open in your other tab…
Before you get completely immersed in watching a tiny cat try to climb up a slide, remember that your time is precious and those balance sheets aren’t going to tell you what you need to know unless you know what to look for.
Let’s start by going over a few of the various types of accounting and how they relate to your business.
The Different Types of Accounting for Agencies
For our agency clients, we primarily focus on financial accounting, management accounting and tax planning.
What does that mean?
Let’s dive in.
What is Financial Accounting?
Historically, financial accounting was developed for publicly traded companies so relevant shareholders and potential investors could compare businesses across industries.
Today, users of financial statements have expanded beyond shareholders and potential investors, to include suppliers, vendors, banks, employees, small business owners and government agencies, as the insights provided by financial statements has proven to be invaluable to the decision making process.
Any business, whether public or private, for-profit or non-profit, can benefit from having well organized financial statements that can be used as a tool to assess the performance and health of the business.
Main Objectives for Financial Accounting
Since financial accounting is the process of collecting, measuring, recording and presenting the transactions of an organization, the main objectives are to:
Create an accurate picture of business activity
Help organizations stay within the confines of the law
Present financial information to business owners so they can make sound investment decisions
Help to define resource allocation, and then help with the decisions on how you may want to adjust resource allocation in the future.
The Levels of Financial Accounting
Financial accounting can be implemented into a business at various levels.
For new businesses, a base level of financial accounting is usually adequate to meet the needs of a growing business. This might entail reporting on cash basis (when cash is received or paid), and setting up a standard set of reports--profit & loss and balance sheet, as well as a high level of analysis.
once your agency begins to scale and grow (possibly more rapidly), you’ll benefit from adding another level of sophistication. There might be a transition to accrual basis accounting (unless you started out that way), and doing a better job of recording revenue.
Recording revenue involves ASC 606, also known as RevRec 606, which is the newest standard for businesses. It drives how agencies need to report their revenue earned and how they can match their cost to that revenue.
At this point you may be asking yourself, “How relevant is financial accounting to me as an agency owner?”
The larger the business, the more valuable it is to have good financial accounting practices; but in any sized business, no matter how small, it will always be very relevant.
Financial accounting is the foundation of business intelligence.
You need a really good financial accounting foundation if you want to build a financial model, track profitability, and develop key metrics.
If you run any sort of creative or marketing agency, these concepts should be pretty clear to you, as they are likely what you have to report on to your clients.
It’s also relevant for any business who wants the ability to directly interact with financial statements; however, it comes secondary to the management accounting question of “what can you do with your strong foundation.”
What is Management Accounting?
Glad you asked.
On the contrary, management accounting is less geared toward the external stakeholders in your company and focused more on internal, day to day operations.
For example, imagine you sell two different services: creative design work and advertising campaigns.
A detailed analysis of your resource allocation in each department may help you better understand how much you should be charging clients for each service.
It’s quite possible that you underbid the creative design work, as it’s common to not take into account back and forth revisions, which run up costs. Management accounting methods will help you understand the margins of each department, what to charge clients, and what to pay your employees.
Essentially, management accounting looks at the different variables that make up the business.
You can think about it in terms of what kind of information you need as a CEO or COO in order to make the right decisions.
It enables you to answer questions like:
“How profitable is X revenue stream”
“How efficiently are we managing X project” or even,
“How well does each individual employee or team inside my company perform and how do we get the right metrics and data to figure this out”
Management Accounting in Action
Management accounting is analyzing your sales pipeline and making judgements based on when revenue is going to get booked, how likely is it to get booked, how it influences your capacity to run your business, or even, how to 4x your revenue.
One example I can think of is, there was an agency we worked with who was doing a big 3x revenue push.
While typically this isn’t the case with most agencies, this one in particular had no problem generating leads and closing deals. They continued to take on more and more clients and hired more and more employees because they were just on a roll.
Although things felt good at the agency, once we got hold of their financials, we were able to show them that their profit margins had shrunk significantly. They had essentially over-hired, and would need to continue at an exponentially larger growth rate, to maintain their previous profit margins. Just loosing one client would have spelled disaster.
Fortunately, because they invested in management accounting, they were able to quickly see how tight their margins had become, and instead of continuing on with the fast pace of taking on new clients and hiring more people, they paused to re-strategize.
They decided to use this newfound knowledge to re-organize their company, pause on hiring and instead, mentor their current resources up into more advanced roles in order to reduce their costs and even out the profit margin.
As an agency owner, management accounting is arguably the main area you should be spending time in because this is where you can discover different ways to grow and be more profitable from the inside.
However, having your financial accounting foundation squared away allows you to see how your organization is performing as a whole and against the industry standard, and it also allows you to present that information to the people who might care: potential investors, partners and anyone who may want to acquire your company down the road.
Cost Accounting (yet another type of accounting)
Cost accounting is a subset of management accounting.
Traditionally, it applies more directly to companies in the manufacturing industry and can help these companies determine how much it costs to produce a single unit at different stages of the production cycle.
But, there are other ways to adapt this accounting methodology to an agency business.
For example, you can replace the word “unit” with the word “deliverable” to see how much a specific deliverable costs to produce at each stage of the project, and you can use this form of accounting to determine how profitable a project is based on the overall revenue produced.
However, you probably won’t need to worry about this type of cost accounting as an agency until you are large enough to have the overhead to gather that kind of data.
Cost Accounting for Large Agencies
If you have the budget, there are some cool things you can learn from cost accounting if your agency is at the higher level: You can track by project, by day, or even down to the person, revenue that’s earned and costs that are incurred.
This will easily allow you to see when a project is starting to get off the rails or identify inefficiencies in the system.
But, if you have less than 70 employees, don’t even bother.
Gathering this type of data is a painstaking process when done without expensive software solutions.
Cost Accounting for Small Agencies
Fortunately, if your agency is on the smaller side, there are other ways to glean the information you are looking for without needing to invest in software.
Sure, the information won’t be 100% accurate - probably closer to 70%, but it’s good enough to base decisions on at the lower level.
Here are some manual hacks to derive that information if you need it:
Track time against projects to calculate the burden cost rate for your employees. This data would include things like PTO, salary, benefits, and tools cost for each individual. Doing so helps with seeing the profitability of a project.
If your agency doesn’t do time tracking, you can just set a controllable margin and look at it from a firm-wide level. Doing so will help you determine if the benchmarks for your projects are off, and will provide granular information to help you see if you scoped something wrong, have inefficiencies, or must change your project.
What is Tax Accounting?
Tax accounting is pretty self-explanatory: it consists of accounting methods that focus on taxes and tax reporting. It involves tax planning, strategy development, and tax return preparation.
Obviously, all businesses need to be prepared to pay taxes, which is why having a tax strategy is important, so I highly recommend reading this article to give you the full rundown on the benefits of tax planning for your agency.
How Does Financial Accounting Differ from Management Accounting and Tax Accounting?
Financial Accounting vs. Tax Accounting
As mentioned, tax accounting specifically focuses on tax reporting whereas financial accounting has more to do with the big picture of your organization’s financial health.
Financial Accounting vs. Management Accounting
One of the main differences is that financial accounting looks at organizations as a whole and is geared toward external users to validate and compare against other similar type businesses. Whereas management accounting is focused on internal users, and assessing and creating strategies for the business.
It focuses on what you need to make the right decisions and helps you determine how profitability compares between two agency sectors, businesses, or clients.
And contrary to financial accounting, management accounting looks more to the future.
Benefits of Outsourcing Financial Accounting for Agencies
Now you know the different types of accounting, but who’s going to handle the financials for your agency?
You have a few options, which include:
Hiring someone in-house
Outsourcing to a firm
There are pros and cons to each option, but if you’re an agency with under 70 employees (5 to 30 especially), outsourcing your financial accounting to a firm can prove to be beneficial and more practical, than an attempt at matching the same capabilities with the cost of an in-house employee.
In-House vs. Outsourcing Accounting
While an in-house employee like a bookkeeper could help with some aspects of the business and potentially cost you less upfront, their knowledge base would be too limited to set your business up for real financial success.
This is especially true if you hope to set your business up for future acquisition.
It isn’t until you reach $3-5 million or more in annual revenue and have at least 50 to 70 people in your company that adding an in-house employee would benefit your business.
At that stage, an in-house employee could help to streamline the company’s financial operations and actually help bridge the gap between an outsourced financial company and an agency, thus vastly expanding the capabilities of both parties.
Although larger agencies can afford to hire someone in-house from the get go, I wouldn’t necessarily recommend doing only that.
Rather than do that, I’d recommend starting with a financial accounting firm, then expanding the scope of your resources to include an in-house person.
An in-house employee can only handle so much of the financial operations in their day-to-day work. A single person would have neither the time nor the resources to properly execute financial accounting plans, which is why having a team of people dedicated to an agency’s account is a more robust solution.
The Biggest Advantage to Outsourcing Your Financial Accounting
The biggest advantage to outsourcing your financial accounting, by far, is that it provides your business with a foundation for the future.
When you first build your company and it’s small, your focus needs to be on creating a simple, effective financial model.
This means having good, high-level reports to derive some analysis from.
Businesses in the beginning of their journey who attempt to complete a financial foundation in-house run the risk of missing out on major tax opportunities, getting into serious trouble with taxes, or, making rookie mistakes that could end up coming back to haunt them.
For instance, dipping into customer funds as an ad agency in order to cover agency cash flow expenses…
Obviously, that’s a big ethical and legal no-no, even if you are able to pay it back before anyone notices.
Understanding Your Agency Finances
The bottom line is that if you aren’t knowledgeable about your financial situation, you are leaving your business open to risk: potential issues with the IRS, limited ability to plan for taxes, and just plain bad decision making.
In the same vein, having a team of professionals analyzing your finances can help plan for hiring and mitigate risk as your business scales up.
So, to bring it full circle, hopefully now you can see why you should have clarity into your agency's financials from a financial accounting perspective.
You can’t sell your agency, bring on investors, or make sound business decisions without it.
Need financial accounting advice? Or maybe you are just looking for deeper clarification on the accounting methods we talked about here.
Send me a message with the subject line "Financial Accounting Help" and we can go over your accounting questions together.