I've never encountered a law firm which did not operate
on a cash basis. That means that your revenues are not
earned from a tax perspective until they arrive in the
door. It doesn't matter if you sent an invoice one day
or one year ago. You have no taxable income to declare
until you receive payment. And your expenses are not deductible
for tax purposes until you actually pay them. So no matter
how many past due bills you have from vendors, until you
pay them, you have no deductions.
The advantages of a cash business are many. First,
most law firms wind up financing a good deal of client
business by way of carrying receivables which are too
large and too old. This often creates a cash flow problem
for midsize and small firms. But just imagine having
to pay income tax on those outstanding invoices before
the cash actually arrive. That's what commercial businesses,
most of which operate on an accrual basis, have to do.
Another strong advantage of cash-basis accounting
is the ability to bring the books to "zero sum"
at year end merely by paying more or less of the outstanding
payables, and often distributing bonuses to partners.
This is a common methodology to ensure there is no taxable
income for professional corporations, and no K-1 income
without matching cash to pay taxes within partnerships.
Cash basis accounting does have some disadvantages.
Because law firms operate on a cash basis, the accounts
receivable and accounts payable do not show on the balance
sheet. Therefore, they do not require any type of "audit"
in order to produce a financial statement. Unfortunately,
in many firms errors abound on these reports, and there
is little incentive to spend the non-billable and administrative
time to clean them up. Likewise, in a cash-basis business
there is no inventory appearing on the balance sheet.
Therefore, errors on work-in-process reports are often
overlooked for the same reasons. These reports tend
to give partners a false sense of potential income when
they are inflated due to accumulation of errors. Accrual-basis
companies must "prove out" or audit their
balance sheet items, which ensures accuracy over the
Perhaps the most serious disadvantage of cash basis
financial reporting is a misalignment between income
and the expenses incurred to produce that income. Simply
put, your monthly cash basis financial statement does
not give you an accurate picture of your actual profitability.
Let me explain.
Consider a month in which the firm is particularly
busy. Billable hours are much higher than usual. Typically,
expenses will also be higher to support the additional
productivity. So expenses will be high. But income will
not reflect the increase in the same month. It may not
be reflected for several months, until it is billed,
and ultimately collected. This creates the illusion
of low income, or even a loss, on the profit and loss
statement for the month in which productivity is higher.
Months later, when the cash receipts arrive, the firm
will show a larger profit than it actually has, because
receipts will be up but the expenses showing on the
profit and loss will be for the current period, not
the period in which those increased receipts were created.
Typically at year end, most firms push hard to collect
as much of their receivables as possible so that bonuses
can be distributed to partners. Profits become distorted
as cash receipts collected from prior accounting periods
far outstrip expenses during the current period. It
is not uncommon for partners to be lulled into a false
sense of security, because they equate bank account
cash balance increases with increased profitability,
when in fact they have only to do with collection efforts.
The problem with the mismatch of income and expense
is that it does not let a firm know each month how are
they really performing financially. In fact, usually
a firm will not realize it is not doing well until it
is too late to do much about it, that is, when the cash
flow stops or slows to a crawl, and vendor bills and/or
payroll cannot be paid.
Consider a scenario where a firm's lawyers have significantly
slowed in productivity. Perhaps certain practice areas
are flat or declining. Maybe there's an attorney out
on disability or maternity leave. If the attorneys or
firm administrator have been working hard to collect
the past due receivables, and maybe even hold back on
paying some outstanding bills, the profit and loss will
reflect a healthy profit despite the decline in productivity.
Continued activities along the same vein will effectively
"mask" the firm's actual monthly losses until
months later, when the decreased inventory results in
decreased billings, decreased receivables, and eventually
a tight cash situation. And of course eventually the
vendor bills will have to be paid. At that point in
time, consider all the attorneys are back in the office,
and working hard. They will be bewildered by the loss
on the income statement when they are all working at
peak productivity. Often they will conclude that there
is "something wrong" with the numbers on the
financial reports, because they just "don't make
sense", and that's true with cash-basis reporting.
By the time the profit and loss actually starts to
show a loss, it will take the typical firm months to
rebuild the inventory, bill it, and begin to collect
to turn the financial situation around. Firms that do
not closely monitor all the key statistical factors,
including amounts billed, hours worked, and so forth,
can easily be misled by cash-basis financial reports,
and therefore fail to take action when the timing is
There are two choices. First, your firm can produce
modified financial reports which include increases/decreases
to receivables and work-in-process and payables, such
that you're looking at your income statement on an accrual
basis. Although this method is for internal use only,
and not for tax reporting, it will match revenues against
expenses for the same period and give a realistic view
of how the firm is doing each month. It will not necessarily
match the firm's cash position. But like any accrual
business, you will come to realize that profits will
only match cash if you properly manage your receivables
and work-in-process. If you do not have a good controller,
however, the chances are you will not be successful
producing a modified income statement unless your accountant
assists regularly, and that can get costly.
A second choice is to produce a monthly snapshot of
what I call Key Statistics. It should show your current
month and year-to-date and prior year's current month
and year-to-date for all numbers which are key to monitoring
the firm's financial health. In no time you will develop
a comfort level with this report, and in a matter of
minutes will be able to assess how the firm is performing.
You'll have the best of both worlds - cash-basis accounting
and regular review of accrual-type information. And
you'll be able to recognize problems and make course
corrections long before your cash flow becomes problematic
This article originally appeared in the January 6,
2003 issue of the Pennsylvania Bar News
Ellen Freedman, CLM, is the Law Practice Management
Coordinator for the Pennsylvania Bar Association.
In that capacity she assists PBA's members with management
issues and decisions on the business side of their
practice, including areas such as technology, human
resources, risk management, and setting up a practice.
Members are encouraged to contact Ellen through the
800 "Hot Line" at PBA headquarters, (800-932-0311
x2228) or through email (email@example.com).