Key Accounting Challenges Facing Professional Services Businesses
Service-based businesses, such as marketing agencies or management consultants, face several accounting issues that are unique to their industry. These challenges may require a particular way to input the information in the accounting system to generate the output management needs to run their business or the implementation of a system that sits on top of the accounting system for the team to use in their day-to-day.
The overall accounting issue revolves around the matching of project-related revenue with the corresponding costs. This is important at a monthly financial statement level, but also to be able to determine which projects are profitable. Resource planning is a significant challenge for this industry, as well as much of the work, is produced by people. The number one question we receive is “Can I afford to hire?”.
We thought it’d be useful to outline the key accounting-related challenges business owners face when the work is project in nature.
Time Tracking and Billing
Tracking billable hours and accurately invoicing clients is crucial for service-based businesses. Efficient time tracking systems are necessary to ensure accurate billing and to avoid undercharging or overcharging clients. Additionally, businesses need to appropriately account for time spent on different projects or tasks for cost allocation and performance evaluation purposes even if you bill fixed prices versus billing by the hour. Utilizing a system like WorkflowMax or Harvest may be critically important in the automation of your invoicing. The most time-consuming process that tends to delay our ability to close the month is when customers are still trying to get their invoices out timely. This has a significant impact on cash flow.
Project Cost Tracking
Service-based businesses often work on projects with varying costs, such as labor, materials, and overhead expenses. Properly tracking and allocating costs to specific projects can be challenging, especially when there are shared resources or indirect costs involved. Accurate cost tracking ensures profitability analysis and helps in making informed business decisions. Systems can help in this area as well. Aside from tracking labor costs on your jobs, you’ll want an automated way for including billable costs on jobs. Many customers fail to invoice billable costs due to the friction involved in getting them together in a timely basis.
Revenue Recognition
Service-based businesses often encounter challenges in recognizing revenue due to the nature of their work. Determining the appropriate time to recognize revenue can be complex, especially when projects are long-term or involve multiple milestones. Accounting standards, such as ASC 606 (IFRS 15), provide guidance on revenue recognition for these types of businesses. Without properly reflecting the timing of when revenue is earned may result in an income statement that doesn’t make any sense to management. Use judgment here as estimates may be good enough for this purpose. Exact matching here may be unattainable.
WIP (Work-in-Progress) Accounting
Service-based businesses may have ongoing projects that are not yet completed at the end of the accounting period. Determining the appropriate valuation of work in progress and the percentage of completion requires careful estimation and adherence to accounting principles, such as percentage-of-completion or completed-contract methods. A system is almost always needed to track your WIP.
Compensation Structure
The compensation structure for service-based businesses can be complex, especially when it involves various types of fees, commissions, or performance-based incentives. Ensuring that the compensation expenses are properly recorded, accrued, and matched to the related revenues can be challenging. Do your best not to create compensation plans that are overly difficult to process at your desired frequency. We have sometimes encountered commission structures tied to when invoices are paid, not sent, that take a lot of time to process. Weigh the benefit of your structure with the ability for it to scale.
Employee vs. Contractor Classification
Service-based businesses often engage both employees and independent contractors to deliver their services. Properly classifying workers as employees or contractors is important for tax purposes and determines the associated payroll taxes, benefits, and other employment-related expenses. Be aware of your state and federal rules regarding the proper classification of contractors. There are stiff penalties for improperly classifying someone as a contractor.
Financial Reporting and Analysis
Generating meaningful financial reports and conducting analysis is essential for service-based businesses. They need to track key performance indicators (KPIs) such as revenue per client, client retention rates, project profitability, and resource utilization to evaluate the financial health of the business and make informed decisions.
Irregular Cash Flow from Project-Based Billing
Many professional service providers bill their clients based on completed projects or milestones. This project-based billing model can result in irregular cash flow, with significant inflows during busy periods and potential cash flow gaps during slower periods. Proper cash flow planning and building financial buffers are crucial to manage the fluctuations in cash flow resulting from this billing approach.
It's important to note that specific accounting issues can vary based on the size, complexity, and industry niche of a service-based business. Working with an accounting team familiar with the unique challenges of service-based businesses can help address these issues effectively.
