Thanks to Seattle area CPA Barbara Schafer for permission to share this article with our clients and readers. This article appeared in the October edition of the Washington State Bar Association publication, ‘Washington State Bar News.’
Who Cares About Accounting (and Bookkeeping)? Hardly anybody (aside from accountants) really likes accounting. Outside the accounting department, it seems to be a bunch of jargon, rules, and requirements that take all the fun out of practicing law. Attorneys have to post their time, staff members have to get their payroll timesheets in, check requests and expense reports have to be submitted, and every month everybody has to “close.” What’s it all about? Why is there so much time and attention paid to accounting? Who cares?
Inside the firm, we need to know if the firm is profitable and what can be done to make it better. Can we hire more people or do we need to do a layoff? Should we buy new computers or lease them? Do we have enough cash to make a distribution to the partners? Outside the firm, there are a bunch of other guys who want to know how the firm is doing. The federal government wants to collect income taxes and the tax return has to be prepared. The city and the state want their excise taxes. The bank wants to know if the loan can be repaid. Vendors want to know if they will be paid. And then there are the auditors from the Department of Licensing, the Department of Labor, or the WSBA looking at a trust account. The accounting has to be right — for all of these compelling reasons.
What Is Accounting?
Where to begin? Accounting is a language, a way for people to communicate about money. It’s a way to compile and summarize information about what has already happened — a system that records, reviews, analyzes, and interprets information. But in the accounting department, we don’t just speak accounting — we also have to do accounting. Policies and procedures are necessary for consistency in reporting and for preventing fraud. All those outside authorities impose standards and reporting requirements, such as filing dates and specific account titles. It’s complicated. So we’ll keep this discussion limited to some basic accounting terms and reports, and why they are important.
Cash Basis or Accrual Basis?
In the legal industry, reporting is done usually on the cash basis, which means that what has been purchased, borrowed, earned, or spent is defined by what happens in the checking account. Income doesn’t count until the money is in the bank. Expenses aren’t included on reports until the check has been cut. Equipment purchases aren’t recorded until the price has been paid. There are a few significant exceptions, but that’s the main idea.
Large firms report on the accrual basis. Income is recorded when it is earned; when the work has been performed, the timesheets have been posted to the billing system, and the client has been billed, including the fee in accounts receivable. Expenses are reported when an invoice has been received and posted to accounts payable. Equipment is recorded at its price, regardless of whether the bill has been paid.
Some firms — but not many, due to the need for sophisticated systems — report internally on both the cash and the accrual basis. Both methods are correct, but generally the accrual basis results in earlier recognition of income, and therefore taxes must be paid sooner. Because taxes are paid with cash, firms prefer to report on the cash basis. The tax reporting method is determined by IRS regulations.
Basic Financial Statements
There are four basic financial statements:
- balance sheet,
- income statement,
- statement of cash flows, and
- statement of changes in owners’ equity.
All four statements can be prepared under both the cash basis and the accrual basis.
Assets = Liabilities + Owners’ Equity
The balance sheet is a list of the assets, liabilities, and owners’ equity of a firm. The balance sheet is always as of a certain date, such as “As of December 31, 2009.” Assets include cash, investments, furniture and equipment, artwork, and buildings or leasehold improvements. They are the things that the firm owns and uses to operate. Liabilities are things like employee payroll taxes that have been withheld but not yet deposited with the IRS; or debts, usually bank loans or notes from partners — what the firm owes. The difference between what is owned and what is owed is equity. It’s like a home mortgage; the difference between the value of your home and the balance you owe on your mortgage is your equity.
It is not a coincidence that the balance sheet balances. It’s a definition; Assets = Liabilities + Owners’ Equity. For example, when $5,000 is borrowed from the bank to buy new computers, both assets (computers) and liabilities (loans payable) increase by $5,000.
Except for the cash account, many law firm owners and managers have a limited interest in the balance sheet. Most are more interested in the “bottom line” found on the income statement (also called the “P&L,” short for “profit and loss”). Statements are prepared for each month and for year-to-date accumulations. Some reports may compare this year to last year or to budget. Income in a law firm is primarily from professional fees generated by lawyers and paralegals. There may also be income from cost recoveries and interest, rent from subtenants, or other sources.
On the expense side, the biggest line items are wages, taxes, and benefits. You’ll also see items like office supplies, rent, library and online research, taxes, employee education, and computer lease payments. Subtract the expenses from the income, and you get the bottom line — net income or net loss. It’s an important number that, over time, determines the continued existence of the firm. The income statement is always for a period of time, for example, “For the 12 months ending December 31, 2009.”
The Statement of Cash Flows
Another report that gets a lot of attention is the statement of cash flows. By monitoring the sources and uses of cash, managers can better understand how the change in the cash balance reflects the results of the operations of the firm, as opposed to its investing or financing activities. If the cash balance increased, was it because the firm was profitable or because the firm borrowed money from the bank? Did new partners buy in? If the cash balance decreased, was it because the partners got a distribution? Was new equipment purchased? Did a loan balance go down? These are clearly very important distinctions. Like the income statement, the statement of cash flows is dated for a specific period of time: “For the month ending December 31, 2009” or “For the 12 months ending December 31, 2009.”
The Statement of Changes in Owners’ Equity
The statement of changes in owners’ equity is the place to look for distributions to partners, contributions of capital from owners or shareholders, member capital accounts, or retained earnings. The account descriptions in this statement depend on the form of ownership of the firm. Is it an LLC, a partnership, a corporation, or a sole proprietorship? Forms of entity are a topic for another discussion.
Timekeeper Production Reports
That covers the basic financial statements. Other reports of great importance in the law firm are related to attorney and paralegal production — time and money. How many hours did each timekeeper work? Who billed for what amounts? Who collected, and how much? What remains in accounts receivable (A/R) or work in progress (WIP)? How old — and likely to be collected — are the A/R balances, and who is accumulating work in the WIP? Every attorney studies these reports — certainly their own numbers. They are at least as important as the financial statements, and like the bottom line, are indicators of the continued success of the firm.
Attorney Trust Accounts
Trust accounting is another critical activity of the law firm accounting department. Trust accounts are composed of funds held by a lawyer on behalf of a client or third person in connection with a representation. Such funds must be held separate from a lawyer’s own property in an interest-bearing trust account as specified in the Rules of Professional Conduct (RPC). The Bar has authority to randomly examine a lawyer’s trust account and to audit a trust account in connection with a disciplinary investigation. Because trust account mismanagement is a frequent basis for imposition of disciplinary sanctions, all lawyers should be thoroughly familiar with their obligations under RPC 1.15A (Safeguarding Property) and RPC 1.15B (Required Trust Account Records) and ensure that non-lawyer subordinates with accounting responsibilities are acting in accordance with the lawyer’s professional obligations. Helpful information about trust accounting can be found in the WSBA publication Managing Client Trust Accounts: Rules, Regulations, and Common Sense, available at www.wsba.org/media/publications/pamphlets/managing.htm.
One hotly debated topic in the legal world is the calculation of overhead. Income and expense can be divided up and spread out among timekeepers or departments to calculate profitability, based on various methods of allocation. Some law firms perform this calculation monthly; some never do it at all. A common practice is to do it annually as part of the attorney compensation analysis. Some firms include depreciation expense or equipment purchases in the calculation, some don’t. Some take into account associate bonuses or partner buy-outs, some don’t. What is the right way? There isn’t one. This is not a standardized report. It’s an internal report that is defined by what the owners agree to do, and what works for one firm may not work for another.
Internal reports can be defined by the firm, but reports for taxing authorities, tax return preparers, lenders, and regulatory agencies must follow accepted formats. We defined some terms, looked at the four basic financial statements, and discussed some topics that are important to law firms and their accounting departments. It seems a lot of people care about accounting. They all want it to be timely, relevant, and accurate — and in terms that meet their specific needs. Accounting is not an end unto itself, but it’s a great tool for business management, and a necessary component of the practice of law.
Barbara Schafer, CPA, CLM, is the author of this great article and has been a member of the Association of Legal Administrators for several years, and has served as the Seattle-area Puget Sound Chapter treasurer. Previously, she was the executive director at Ogden Murphy Wallace and the firm administrator at Bennett Bigelow & Leedom. She is now a consultant and sole proprietor of her CPA firm. She can be reached at email@example.com.