Professional Services: Cash vs Accrual Timing to Reveal True Project Profitability

The Core of the Timing Problem: Cash vs. Accrual Accounting

A project finishes, the final invoice is paid, and the numbers show a healthy profit. Yet, the company bank account feels tight, and you are not sure which clients are truly driving the business forward. This gap between perceived success and cash reality is a common challenge for professional services firms. The root cause is almost always a mismatch in timing: the lag between performing work, sending an invoice, and receiving payment. Understanding how to recognize revenue for agency projects correctly is not just an accounting exercise; it is fundamental to managing cash flow, assessing profitability, and preparing your business for growth and scrutiny. This guide explains the journey from a simple cash-based view to the accrual-based reporting that investors and auditors expect.

For many early-stage agencies, accounting starts and ends with the bank account. This is cash accounting: revenue is recorded when a client payment arrives, and expenses are recorded when you pay a bill. While simple, it provides a dangerously misleading view of your performance. A large upfront payment can make an unprofitable month look like a huge success, while a month of hard work with delayed invoicing can appear as a failure. This directly answers the question, "Why does my bank balance say one thing, but my project profitability another?"

The solution is accrual accounting, which is built on the matching principle. The Matching Principle: This principle dictates that you should recognize revenue as it is earned and match the expenses incurred to generate that revenue in the same period. The timing of income recognition shifts from the payment date to the date you deliver the service. This distinction between cash collected and revenue recognized is the most critical concept in project-based accounting.

When a client pays you before the work is done, that cash is not yet revenue. In your accounting system, like QuickBooks or Xero, it is recorded as a liability called Deferred Revenue. It represents your obligation to deliver a service in the future. Only as you complete the work does that liability turn into earned revenue on your profit and loss statement. The reality for most early-stage startups is pragmatic: they start with cash and slowly adopt accrual concepts as the need for accurate reporting grows.

How to Recognize Revenue for Agency Projects Using Work-in-Progress (WIP)

To bridge the gap between cash reality and accrual principles without complex accounting, you can use a powerful tool: Work-in-Progress (WIP). WIP represents the value of work you have performed for a client but have not yet invoiced. WIP is an asset on your balance sheet because it is value you have created that will convert to cash in the future. For financial reporting for agencies, tracking WIP is the key to understanding true monthly performance and avoiding cash-flow gaps caused by guessing at unbilled work.

Informal WIP tracking can start in a simple spreadsheet. It answers the crucial question: How do I match revenue to the work we have done before sending an invoice? To do this effectively, you must first determine a consistent method for measuring project completion. Common methods include:

• Milestone Completion: Revenue is recognized when a specific, pre-defined project milestone is completed and accepted by the client.
• Hours-Based: Progress is measured by the proportion of hours worked to date against the total budgeted hours for the project.
• Cost-to-Cost: Progress is calculated based on the ratio of costs incurred to date to the total estimated project costs.

Choosing a method and applying it consistently is essential for accurate project-based accounting. Let's walk through an example where the payment schedule does not align with the work schedule, using a milestone or hours-based completion estimate.

A Practical Example: From Misleading Cash View to Accurate Accrual View

A scenario we repeatedly see is a project where billing terms create a distorted financial picture. Consider this project:

Project Details:

• Total Contract Value: $30,000
• Duration: 3 months
• Billing Terms: 50% upfront ($15,000), 50% on completion.

Month 1 Performance:

• Your team completes 40% of the total project work.
• Your direct project costs (salaries, software) for the month are $8,000.
• You received the $15,000 upfront payment.

Here is how the two different views would report your Month 1 Profit & Loss (P&L):

Cash View P&L (Month 1)

• Revenue: $15,000 (the cash that hit your bank)
• Costs: $8,000
• Profit: $7,000

This P&L suggests an incredibly profitable month. However, it is misleading because you have recognized cash for work you have not yet done. This can mask underlying issues with project scope or efficiency until it is too late, leading to poor decisions about hiring or spending.

Accrual/WIP View P&L (Month 1)

• Earned Revenue: $12,000 (40% of the $30,000 total contract value)
• Costs: $8,000
• Profit: $4,000

This provides a more realistic picture of performance. You see the actual profit generated by the work performed this month. On your balance sheet, you would now have an asset for WIP of $12,000 (the value you earned) and a liability for Deferred Revenue of $3,000 ($15,000 cash received minus $12,000 earned). This method prevents mis-timing project revenue and costs, giving you a clear view of profitability long before a project ends.

Graduating to Formal Revenue Recognition for Agencies

While a WIP spreadsheet is a great start, as your agency grows, so do the expectations of external stakeholders. Relying on cash accounting when investors or tax authorities expect accrual numbers can jeopardize funding rounds and force expensive restatements. This is when an informal process must become a formal accounting policy.

For US companies, the governing standard is ASC 606. The standard, "ASC 606 is the official US GAAP accounting standard for 'Revenue from Contracts with Customers'" (ASC 606). In the UK and other regions using International Financial Reporting Standards, the equivalent is IFRS 15, which is based on very similar principles. Both frameworks are designed to standardize how companies report revenue.

"The core principle of ASC 606 is to recognize revenue when control of goods or services is transferred to a customer." This aligns perfectly with the WIP methodology, where you recognize revenue as you perform the service. The goal of the standard is simplification; in fact, "ASC 606 simplifies and replaces five older, industry-specific revenue recognition rules into a single framework."

The Five-Step Model of Revenue Recognition

Both ASC 606 and IFRS 15 use a five-step model to determine when and how much revenue to recognize. Deloitte provides guidance on measuring progress under these standards. Understanding these steps is key to formalizing your process:

1. Identify the contract with the customer. A contract must be legally enforceable and establish the rights and obligations of both parties.
2. Identify the performance obligations. These are the distinct promises to deliver goods or services. A single contract might have multiple performance obligations.
3. Determine the transaction price. This is the total compensation you expect to receive in exchange for fulfilling the contract.
4. Allocate the transaction price. If there are multiple performance obligations, you must allocate the total price to each one based on its standalone selling price.
5. Recognize revenue as you satisfy each performance obligation. This is the crucial step where timing is determined. For professional services, revenue is typically recognized over time as the work is performed.

So when does this become critical? The pressure to formalize typically comes from investors and lenders. What founders find actually works is to get ahead of this requirement. "By the Series A stage, investors' due diligence teams will typically ask how a company recognizes its revenue." See our guide on when to switch from cash to accrual accounting.

Later, the requirement becomes mandatory. "A company's first formal financial audit is typically required by a Series B lead investor or a significant lender." At this point, your informal WIP spreadsheet is no longer sufficient. An auditor will need to see a clearly documented, consistently applied revenue recognition policy inside your accounting system. They will test your calculations and ensure your financial statements are accurate according to US GAAP or IFRS.

Practical Takeaways: Implementing Proper Revenue Recognition

The journey from simple cash tracking to formal accrual accounting is a gradual one, aligned with your company's growth. The key is to implement the right level of rigor at the right time. Managing client payments and understanding project profitability do not have to be overly complex, but they do require moving beyond the bank balance as your single source of truth. Here are three practical steps based on your agency's stage:

1. Early Stage (Pre-Seed/Bootstrapped): Track WIP in a Spreadsheet.
2. Begin today. For each project, log the total contract value, the percentage complete at the end of each month, and the corresponding earned revenue. Compare this to your project costs. This simple step will dramatically improve your understanding of profitability and highlight which projects are truly profitable versus those that just provide good cash flow.
3. Growth Stage (Approaching Series A): Formalize Your Policy.
4. Start the conversation with your external accountant or fractional CFO. It is time to translate your WIP spreadsheet logic into a formal revenue recognition policy. This document should define your chosen method for measuring progress (% complete) and will be essential for investor due diligence. It sets the foundation for a future audit.
5. Scaling (Series A and Beyond): Implement in Your Accounting System.
6. Work with your finance professional to implement your policy directly within your accounting software. In Xero or QuickBooks, this involves using journal entries to book WIP and Deferred Revenue monthly. This ensures your official financial statements reflect accrual-based reality, making financial reporting accurate and audit-ready.

Adopting these practices provides a clear, consistent view of your agency's financial health. It enables better decision-making, highlights your most profitable engagements, and ensures you are prepared for the financial scrutiny that comes with success. The goal is progressive formalization, not perfection from day one. The journey from simple cash tracking to formal accrual accounting is a gradual one, aligned with your company's growth.

Frequently Asked Questions

Q: Can I use cash accounting for taxes but accrual for management reports?
A: Yes, this is a common practice for smaller businesses. You can maintain internal reports on an accrual basis for better decision-making while filing taxes on a cash basis if you meet the specific thresholds set by tax authorities like the IRS in the US or HMRC in the UK.

Q: What is the easiest way to calculate "percent complete" for a service project?
A: The simplest method is often based on milestones (e.g., 25% complete after client sign-off on creative concepts). For projects without clear milestones, using the ratio of hours worked to total budgeted hours is a practical and defensible alternative that auditors generally accept when applied consistently.

Q: How does revenue recognition differ for fixed-fee vs. retainer projects?
A: For fixed-fee projects, you recognize revenue based on progress toward completion (e.g., % complete). For retainers, if the service is delivered consistently each month, you can typically recognize the monthly retainer fee as revenue in that month. The key is matching the revenue to the delivery of service.

Q: At what revenue level should we switch to formal accrual accounting?
A: There is no magic number, but the switch is typically driven by external requirements. Most companies formalize the process when seeking Series A funding or taking on significant bank debt, as these stakeholders require GAAP or IFRS-compliant financial statements to assess the business's health accurately.