Was It Really a Bad Year? Why Your Agency's Books Belong on Accrual, However You File

By Craig S. Cody, CPA, Certified Tax Coach.

Here's the answer up front. Keep your agency's books on the accrual basis, whether you file your taxes on the cash method or the accrual method. Income belongs in the month you do the work, not the month the money shows up. Money you collect early sits on the balance sheet as deferred revenue until you earn it. Get that wrong around December and a good year looks great, the next year looks bad, and neither one is true.

I had a conversation recently with a prospect who told me last year was a really good year, and this year was turning out worse than they expected. When we did a deeper dive during our tax planning analysis, we found money they'd received in December for work they were going to do in January and February. The income was picked up in December, which inflated last year. The expenses to do that work landed this year, with no income against them, and that drove this year's profit below what they expected.

They weren't necessarily having a bad year. They just weren't accounting for the income correctly.

What Actually Happened?

The money arrived in one year and the work happened in the next. The books followed the money.

Here's an example with made-up numbers. Say a client pays you $120,000 in December for a project you'll deliver in January and February. Delivering it costs you $80,000 in payroll and freelancers, all of it in those two months.

If that $120,000 gets booked as December revenue:

• Last year shows $120,000 of revenue with no cost against it. Your best year ever, on paper.
• This year shows $80,000 of cost with no revenue against it. A $40,000 profit job shows up as an $80,000 loss.

That's a $120,000 swing in each year, in opposite directions. The project was profitable. The books said otherwise.

Was It Really a Bad Year?

Maybe not. That's the point.

When the books follow the money instead of the work, you can't trust either year. Last year looks better than it was, and this year looks worse. If you've been staring at this year's P&L wondering what went wrong, the first question isn't about clients or pricing. It's whether income from this year's work got booked in last year.

It matters because you run the agency off those numbers. A great-looking year is when owners raise salaries, take bigger distributions and hire ahead of the work. A bad-looking year is when they cut people, panic about pricing or chase new clients they don't need. Both can be decisions made on numbers that were never right.

Why Should Your Books Be on Accrual Even If You File on Cash?

Because how you file your taxes and how you run your agency are two different questions.

The cash method tells you when money moved. That's fine for a tax return, and for a lot of agencies the cash method is the better filing choice. But it can't tell you whether a client, a project or a month made money, because the revenue and the cost of earning it often land in different months.

Accrual matches them. Revenue goes in the month you do the work, and the cost of that work goes in the same month. That's the only way your margin means anything.

So the answer is one set of books, kept on accrual, with an accrual to cash adjustment on the tax return if you file on cash. I've written about how that works in Should Your Agency Pay Tax on the Cash Basis? One Set of Books, Two Answers.

The prospect I mentioned filed on the accrual basis. Being on accrual for tax didn't make the books right. The December money still went in as December income.

What Is Deferred Revenue?

It's money you've collected, or billed, for work you haven't done yet. On the balance sheet it's a liability, because you owe the client the work.

As you do the work, it moves off the balance sheet and onto the P&L as revenue. In the example above, the $120,000 sits in deferred revenue on December 31. In January and February it moves into revenue as the project gets delivered, right next to the $80,000 it cost to deliver.

For agencies, deferred revenue usually comes from three places:

• Retainers billed in advance, like a January retainer invoiced and paid in December.
• Project deposits, where a client pays half up front.
• Year-end prepayments, when a client has budget left in December and wants to spend it before it disappears.

That last one is the trap. December is when clients are most likely to send money for next year's work, and it's when you're least likely to be watching how it gets booked.

Does It Change Your Taxes?

It may not. That's a separate question, and it's a good one to ask your CPA.

If you file on the cash method, money is generally taxed in the year you receive it, no matter how your books treat it. If you file on accrual, the default rule also includes an advance payment in income in the year you receive it. There's an election under Regulation 1.451-8 that can push the unearned part into the next year, and whether it applies to you, and whether you're already using it, is worth a conversation.

But don't let the tax answer decide how you keep the books. The tax return is a filing position. The books are how you see your agency.

How Do You Fix It?

Most of this is setup, done once, then a monthly habit.

• Set up a deferred revenue account on the balance sheet, so early money has somewhere to go besides the P&L.
• Put the service period on every invoice, like "January 2027 retainer," so whoever books it knows which month it belongs to.
• Book revenue by the month the work happens, and move deferred revenue onto the P&L as you deliver.
• Tie out deferred revenue at every month end against a list of the work you still owe, client by client. If the balance doesn't match the list, something got booked in the wrong month.
• Look hard at December. Before you close the year, go through every December receipt and ask what month the work is in.

If your books already have it wrong, have last year and this year restated for your own use, with the early money moved into the months it was earned. You'll finally be able to compare the two years honestly. You may find out this year is fine.

Who Is This Not For?

If you bill every month, in arrears, for work you already did that month, you probably won't have much deferred revenue. You still want accrual books, because your receivables need to be on them, but the December problem is less likely to be yours.

And if you're hoping this lowers your tax bill, it may not. This is about seeing your agency clearly. Any tax benefit is a separate question.

What Can You Do This Week?

Pull every deposit from last December. For each one, ask what month the work was in. If any of it was for January or February work and it was booked as December revenue, you've found at least part of the reason this year looks worse than last year.

Then look at this December before it gets here. Your clients are about to start spending what's left of their budgets.

Frequently Asked Questions

Should an agency keep its books on cash or accrual?

Accrual, whether the agency files its taxes on the cash method or the accrual method. Accrual books put revenue in the month the work is done, next to the cost of doing it, so your margin by month, client and project means something. If you file on cash, the difference is handled with an accrual to cash adjustment on the tax return.

What is deferred revenue for a marketing agency?

Deferred revenue is money an agency has collected or billed for work it hasn't done yet, like a retainer paid in advance or a project deposit. It sits on the balance sheet as a liability and moves onto the P&L as revenue in the months the work is delivered.

Why does my agency look profitable one year and unprofitable the next?

One common reason is timing. If money received in December for January and February work was booked as December revenue, last year's profit was inflated and this year carries the cost of the work with no revenue against it. Restating both years by the month the work was done often shows the swing wasn't real.

Does booking deferred revenue change my taxes?

It may not. On the cash method, income is generally taxed when received regardless of the books. On the accrual method, advance payments are included when received by default, though an election under Regulation 1.451-8 can defer the unearned part one year. Ask your CPA which applies to you.

How do I fix income booked in the wrong year?

Set up a deferred revenue account, put the service period on every invoice, book revenue in the month the work happens and tie out deferred revenue every month end against the work you still owe. For past years, have your books restated for your own use so you can compare them accurately.

Let's Talk

A bad year and a badly booked year look exactly the same on a P&L. The only way to tell them apart is books that put the income where the work is.

If you'd like a second set of eyes on your own numbers, book a Free Tax Analysis. It starts with a short 15-minute call, so nothing sensitive changes hands before we've talked. Email me at craig@ccodycpa.com to schedule it, or request one with the form on this page.

Craig S. Cody is a CPA, Certified Tax Coach, and retired NYPD Lieutenant. His firm works with more than 70 marketing and advertising agency owners every month, helping them keep more of what they make through proactive tax planning.

This article is general education, not advice for your specific situation. Confirm your own facts with your advisor before acting.