Agency Accounting 101 with Chris Hervochon – Episode 27

About This Episode:

In this episode of Agency Profit Podcast, Chris Hervochon from Better Way CPA shares his expertise and passion for agency accounting. This Agency Accounting 101 episode breaks down everything you need to know to keep your accounting data clean and organized, track your core metrics, cash flow forecast, and answer your most important business questions with accuracy and ease.

About Chris: 

Chris Hervochon is often referred to as the Michael Jordan of accounting (and by often, I mean just once by me in his introduction). A graduate from Elon University with a degree in Accounting and minor in Finance. He is a Certified Public Accountant (CPA) in South Carolina and Pennsylvania, and also holds the Certified Valuation Analyst (CVA) certification. A Certified QuickBooks Online ProAdvisor, and have earned the Data Analytics Executive Certificate from the AICPA.

In 2018, he was one of only 41 CPAs honored by the AICPA as a member of the Leadership Academy’s tenth graduating class. In 2019, I was named as one of CPA Practice Advisor’s “40 Under 40” in the accounting profession.
He started his firm called Better Way CPA, where he helps creative, digital marketing agencies, and service-based businesses with intelligent, actionable accounting.

Want to See More of Chris? Follow him online:

• Website
• Better Way CPA Facebook
• Better Way CPA Instagram
• Chris Hervochon’s Twitter
• Chris Hervochon’s YouTube Channel

Resources:

• From Freelancer to Agency Ebook 
• Cash Reserves Calculator
• Wayfinder

Time Stamps:

Useful insights and questions from this episode:

• Intro 0:00
• Who is Chris 01:00
• How Chris Started in the Service Business Industry 2:20
• What Makes Accounting Service Businesses Unique 4:48
• Why is it Important for Agencies to Have a Clean Accounting Data 8:58
• Common Mistakes Agencies Commit in Terms of Accounting 10:04
• Why Service Businesses Must Use Accrual Basis 13:53
• Revenue Recognition for Accrual Accounting 17:25
• Benefits of Cloud-Based Accounting 19:48
• Cash Reserves for Agency’s Survival 22:30
• The Right Corporate Entity for Your Business 28:10
• Biggest Problem for Service Agencies’ Chart of Accounts 30:35
• Freelancers Vs. Full-Time Employees 35:00
• Allocating Your Salaries 39:48
• Gross Profit Vs. Net Profit 41:50
• Maximizing Profit: Pricing and Operating Perspective 45:50
• Outro 50:00

Agency Accounting 101 with Chris Hervochon

Most agency owners see accounting as a necessary evil to running their business, rather than a critical function. Most of the time, I find that resistance comes down to a lack of understanding as to why accounting is important, and how it can help make running your agency easier. Accounting isn’t just all about a boring balance sheet and debits & credits.

That’s why I wanted to bring my friend Chris in to demystify accounting for agencies and help clarify how to set this area of the business up to serve you rather than scare you.

According to Chris Hervechon:

“Marketing agencies are a lot like accounting firms. How they operate. It’s a different service. Sure, it’s more creative, generally speaking. But they’re both service-based businesses.”

What Makes Accounting for Service Businesses Unique 

According to Chris, there are a lot of agency owners that do not realize that service businesses are very different than almost every other service business.

And, its main difference happens above the margin. So your margin is your gross revenue minus all the variable costs that go into generating that gross revenue. 

If you think about a retail store that tends to have lower margins, your gross revenue is going be all the stuff that you sell.

Let’s say you sold a television for $850, then that’s already your gross revenue. If it cost you $500 to buy the television, including taxes and licenses, then your gross profit is $350.

On the other hand, service-based businesses tend to have higher margins. There are generally fewer variable costs going into generating the revenue. Margin is largely based on human capital – the amount of effort agency owners and their employees put into earning revenue. 

Why is it Important for Agencies to Have Clean Accounting Data?

The entire purpose of accounting is so that you can ask questions about your business and get accurate and reliable answers.

According to Chris, your accounting data should be set up to help you answer your most important questions about the agency. Things like:

• Is this project profitable? 
• Will this service be profitable? 
• Is this niche profitable? 
• What are the fixed expenses? 
• Where can I cut costs to be more profitable? 
• What’s too expensive? 
• What’s not expensive enough? 
• Am I spending enough or too much on my marketing?

Through these questions, you will be able to know your agency’s trajectory and make better decisions. The trick is setting up your chart of accounts in the right way.

Common Mistakes Agencies Make in Terms of Accounting 

You will be surprised at how agencies make the same mistakes.

The first and most common mistake is waiting for the end of the year to look at accounting info. Chris recommends sitting down with your accountant on at least a quarterly basis, but ideally a monthly basis to review the numbers.

The second big mistake is trying to do accounting on your own as a business owner. Even with a financial background, it’s generally best to hire an accountant to have a second set of eyes on your books to look over things like your financial statements, cash flow statement, and your balance sheet to see if there is any room to trim the fat.

A third common mistake is using the same chart of accounts structure as every other kind of business. Since agencies have a different business model than say, product companies, they should also have a different structure to their chart of accounts. The key here is setting up the COA based on the questions you are setting out to answer on a regular basis.

For most agencies those questions are going to be things like:

• How much Adjusted Gross Income did we make?
• What was our Gross Profitability?
• How does that break down by client, project, service, or team?
• What % of my AGI is Production Payroll, Admin, Sales & Marketing, or Facilities?
• etc.
  

Finally, far too many agencies aren’t using accrual accounting practices and instead account on a cash basis.

Why Service Businesses Should Account on an Accrual Basis

Looking at things on an accrual basis is certainly a change for a lot of people, especially small businesses. But it’s something that you need to do if your agency is growing past just a handful of people. Without accrual accounting, it’s almost impossible to forecast cash flow accurately. Accrual accounting is critical to answering questions like:

• How is my business doing? 
• How is it looking for next month? 

In a service-based business, accrual accounting is important because it’s reflective of the business model. It’s reflective of the way that value is earned and value is actually accrued over time. So if you run a service-based business, you should be doing your books and you’re counting on an accrual basis so that you can get accurate insights into your business.

Accrual-based accounting is more time-intensive. It does require more expertise and so to do it is more expensive. But there is a line where the business is big enough. Generally, we recommend moving to accrual accounting as you cross over the $1M in revenue mark.

Revenue Recognition for Accrual Accounting 

What’s the best way to recognize revenue in your agency? Should you base it on hours spent, % complete, the time elapsed, or something else?

Chris says that as a best practice – use your contracts with clients as a reference to identify the best way to recognize revenue for clients and projects.

Variables like how many deliverables there are, when you get paid for deliverables, and the schedule on which you’re doing work and getting paid are all considerations in the best method to earn your revenue. Your contract language should make it clear how to earn revenue in a way that’s reflective of reality.

Benefits of Cloud-Based Accounting 

Chris states that as an agency owner, doing your own finances in a spreadsheet is a bad idea. He encourages agencies to use cloud-based accounting software like QuickBooks Online.

The reason being is if you have an accountant who’s halfway across the country, you could be looking at the same numbers in real-time while doing the same thing

And, what you can effectively do with cloud-based accounting systems is offload the security to somebody who’s probably a lot better at it than you are. You must protect your business information and there have been a lot of hackers targeting these hosted type platforms like QuickBooks. Contrary to popular belief, cloud-based accounting systems can be much safer than most locally installed systems for small businesses.

The third thing is that cloud-based accounting systems make it easier to plug in other applications. Whether it’s a bill pay system or an expense tracking system or maybe it’s just other marketing data that you can then combine with your financial data to make it leverage data.

Non-financial data equals leverage data. When you can combine these two things, you can get greater insights into your agency.

Cash Reserves for Agency’s Survival 

Chris Hervochon recommends that agencies must set aside between two to six months’ worth of fixed expenses to plan for slow times and fund growth. Fixed expenses are expenses that are going to exist in the business, whether or not you generate revenue for the whole month including overhead and payroll costs.

How do you determine how much cash you need to set aside in your agency? It comes down to measuring the risk levels in your business. Chris created this calculator to help you figure it out for yourself.

Service Agencies’ Chart of Accounts 

The chart of accounts is the foundation on which the insights that you get from your accounting data is built, or from which you get the insights that you want to build. This is something that a lot of people don’t think about a whole lot when they’re setting up books for the first time or if they’re hiring an accountant that doesn’t know a lot about service businesses.  

Chris mentioned that the agency owners don’t want to sift through a ton of data and do a bunch of math. So when it comes to setting up your chart of accounts as a service business where some of the best practices we want to make sure we’re keeping an eye on the inflows and outflows of our businesses and considering the questions we want to answer when setting things up.

Ideally, our chart of accounts should help us quickly identify things like:

• Adjusted Gross Income
• Gross Profitability (by client, department &/or project)
• Our spending as a % of AGI for Production, Overhead, Facilities & Sales/Marketing
• Etc.
  

Side note: our Agency Profit Toolkit is a one stop shop for you to be able to outline some of these crucial profitability numbers to a potential buyer. Spreadsheets, templates and training videos, you name it, it’s all in the toolkit. Grab yours free at the link below:

Problems Agencies Encounter with Their Chart of Accounts

The biggest problem Chris generally sees is what we would refer to as a sprawling chart of accounts where there are many unused or rarely used accounts.

The biggest mistake is a sprawling chart of accounts where you’ve got one account for every little transaction. So if you have accounts that you know, on a very regular basis have one transaction per month or one transaction per year, you’ve got way too many accounts. 

This tends to make bookkeeping and running reports difficult because it increases the complexity and cost of doing bookkeeping accurately.

The three biggest things to focus on in the COA, according to Chris Hervochon are:

• You’ve got to be able to get to track gross margin.
• You’ve got to break out your salaries and wages.
• And, make sure that your chart of accounts isn’t enormous because it is going to be impossible to manage. 

Freelancers Vs. Full-Time Employees

Freelancers, generally speaking, are going to go above the line because you’re only going to bring them on for certain projects, certain clients, certain services, whatever it is. They’re 100% variable because you’ve already generated some sort of revenue or you think that you’re going to generate revenue because you have a signed contract. So there should be some sort of a contract labor line in your chart of accounts to get you to that gross profit number. 

Chris said that a lot of people are tied up with the idea of the relationship or the contractual relationship they have with an individual as it relates to “Are they an employee? Or are they a contractor?” 

There are four components that you must ask yourself to determine if they’re an employee or a contractor: 

• Are they fixed or are they variable?
• Are they contractors or are they employees? 
• Am I controlling when and where they do the work? 
• Am I providing them with tools or software?

This is an important point that you’re making about the relationship that that person has with variability. If you have a person that isn’t technically an employee of the company, but you pay them $2000 a month which is going to be more of a fixed cost.

And, this is how you classify people between contractors and employees. If you control how, when, and why they do their work and you provide training and you provide the equipment and the software and all of that stuff, they’re an employee. If they can do the work unsupervised, they’re going to provide you with a deliverable. You’re not controlling where they work or when they work. Then they’re a contractor. 

Most businesses want more contractors because contractors represent less risk. Often people try to maintain contractor relationships with people who really should be classified as full-time employees. Chris recommends being careful as changing laws around freelance workers could put your business in a compromised position. 

Allocating Your Salaries

According to Chris, time tracking will help you accurately allocate salaries within your accounting data so you can track gross profitability on clients and projects.

Chris stresses the importance of tracking time, as there’s no accurate way to track gross profitability at the client or project level without that data.

Chris mentioned that you’ve got to make sure that when you’re allocating those expenses you’re allocating the fully loaded expenses which include salaries, benefits, and taxes. The full cost of having that employee is what you want to allocate. You can’t just allocate the salary without the rest.

Gross Proft Vs. Net Profit 

It’s important to define what is gross profit and what is net profit because I think a lot of agencies now are starting to look at gross profits on projects I think is a good thing. But then a lot of them are not clear on what that means and what should and shouldn’t be factored into that. 

Gross profit is going to be gross revenue, less the costs of delivery (variable expenses like ad-spend, contractors, etc.) and the cost of your team’s time (based on their cost-per-hour and the amount of time they spent)

Gross profitability is key to track at the client and project level. Net profit is generally only necessary to evaluate on a wider scale (agency-wide, or by department)

For more on how to calculate profitability in your agency, check out our blog post on the topic.

Maximizing Profit: Pricing and Operating Perspective 

Chris believes the move to Value-Based Pricing is the right move for most agencies. That means pricing on the value they deliver to the client, not the time they spend.

In this Agency Accounting 101 podcast, Chris mentioned a really good example is a digital direct marketing agency that is running ads. “You should be charging higher if your ads are more effective than the next agency down the street. You should be pricing based on the value that you deliver and you should not need to be measurable.”

He recommends thinking about how the value of your services might change based on who’s receiving them – and adjusting pricing accordingly. An example is creating the same % increase for two businesses of a different size. The value of a 1% increase for a $1M a year business and a $100M a year business is very different. The price should be reflective of that difference in relative value.

Lastly, he recommends sitting down with your accountant regularly to review the expenses in your business. They can get out of control quickly, especially in a software-heavy society that we have now.

By being vigilant about where money is being spent, you’ll often find opportunities to put money to work in more effective areas and keep your cash flow reserves where they need to be for rainy days.

Agency Profitability Tool Kit

If you’re looking for more resources to help you improve your agency’s profitability, then check out the Agency Profitability Tool Kit – it’s full of the same templates and checklists we’ve used with consulting clients to help them improve their profitability by over 100% in under 60 days.