In the first installment in this series, I outlined the proposal pending before Congress to require essentially all law firms with more than one or two dozen lawyers (more than $10-million in annual revenue) to switch from cash to accrual accounting.
In this installment I promised to talk about the financial impact. There are actually two: A very large one-time transitional cost in the form of an unexpected, front-loaded tax liability that partners will have to pay over a proposed four-year period; and second, the ongoing costs of complying with the increased complexity and uncertainty of accrual accounting vs. cash accounting.
Let’s take the second first. While it’s difficult to put a precise number on it, everything that’s been written on this topic—from the likes of the PriceWaterhouse Coopers law firm group and the American Institute of CPA’s—and everyone I’ve spoken with, including CFO’s of AmLaw 25 firms, predicts it will be very substantial: More headcount in the financial staff function, more tracking and recordkeeping, more complex client engagement letters and pricing parameters, and higher fees paid to outside accounting firm. All these costs will be incurred in perpetuity.
Here, for example, are some excerpts from the PwC white paper on this topic. At the “executive summary” level:
Unfortunately, the accrual method of accounting for US federal tax purposes likely will be more
complex to manage after the conversion. Analyzing income and deductions using the accrual
method (as compared to cash), encompasses a larger spectrum of specialized rules.
But it’s not just the accounting function; the change would reach its tentacles into the very nature of client engagements, pricing, and fee negotiations:
Given the increased complexity of the rules surrounding the accrual method to determine
taxable income, process changes must be considered to ensure compliance – either adding new
processes or revamping others. Analyzing the existing portfolio of work to calculate gross
income, accrued expenses, and bad debt deductions is likely to take a significant amount of time
and resources. For example, different engagements may have varying realization rates as each
client may have agreed to different billing rates. Thus, contract terms will need to be reviewed
and considered. In addition, system platforms may also need to be adapted to help automate
Process change should also be considered in the business development stage. Should firms shift
to greater progress billing arrangements when engaging clients? It may also be prudent to
review on-going large engagements and determine whether a different billing agreement would
be advantageous to ensure a timely match between when cash is received and when income
must be reported for tax purposes. Process changes may also need to occur with respect to
Finally, lest we leave out the likes of PwC itself, we may all look forward to paying richer fees to them for their help:
The conversion from the cash to accrual method for tax purposes will likely have a significant
impact on the auditing of law firm financial statements. Additional testing of the A/R and the
build-up of work in process will be required including the internal controls established to
provide for the accurate statement of these amounts as well as management’s estimate of the
reserves for these accounts. Moreover, the beginning of the year amounts will also have to be
Similarly, additional work will be required for accrued expenses with both beginning of the year
and end of the year amounts subjected to testing. Internal controls established for determining
these amounts will also need to be tested. Further changes include the revision and review of
footnotes and disclosures. Accordingly, the cost of the audit likely will increase
My conversations with law firm CFO’s bear this out, and although many are just at the beginning of starting to think through the consequences, it’s safe to say that every single one is more or less constantly raising his estimate of the ongoing costs of compliance the more they look into it. These remarks (private email) are representative:
I also came away [from the online PwC presentation] with the impression that the compliance costs for a law firm may be much higher than I’ve been estimating – as I said to you, coming up with “simple” accrued expenses is not going to be that big of a deal, but to do the accounting for the phantom income over a 4 year period for a changing group of partners that gets complicated by the fact that we have international partners – it does raise a level of complexity that we don’t have now.
Now, let’s talk about the upfront transitional costs—this is also why Congress may be tempted to shift into grabby mode and adopt this radical change outside the framework of any comprehensive tax reform.