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.
The best estimate I’ve seen of the one-time revenue infusion comes (again) from PwC, who estimated it at $50-billion, for all affected professional service firms.* Just how tantalizing could $50-billion be to the eyes and hands of our 535 paragons of selfless virtue? Here are some comparables, to put context around that figure. $50-billion is equivalent to:
- An extra four months of tax receipts from all corporations in the US;
- The price of 12 Nimitz class aircraft carriers; or, if you want to have much more fun with it than that, and with a nod to Super Bowl Sunday now 48 hours away;
- The value of all 33 NFL teams—with about $20-billion in walking-around money left over.
With the help of one of those AmLaw CFO’s, I’ve come up with some estimates of the impact on you.
Begin with the premise/assumption that the amount of “phantom” non-cash income that would be subject to taxation is three months of revenue, and that equity partners would pay tax on that at the top federal rate, 39.6%. We’ll round to 40%, but we will not add any booster for state and local income taxes, which of course in jurisdictions such as the one I’m sitting in—New York City—take the marginal rate to 50% and above in no time flat. (Note to the green eyeshade crowd: To arrive at the figures for the impact on individual partners in each of the following cohorts, I assume (a) that 100% of each firm’s net income is distributed out on K-1’s; and (b) that equity (and no non-equity) partners receive 100% of that distributed income.)
Here are the numbers:
- Revenue for AmLaw 50 firms in 2012 was $60B. So the total phantom income impact is $15B, total tax impact at 40% = $6B. According to the AmLaw 2012 figures, there were 12,533 equity partners in the AmLaw 50, for an average personal tax liability of $478,736.
- Revenue for AmLaw 51-100 firms in 2012 was $25B. So the total phantom income impact is $6.25B, and the total tax impact at 40% = $2.5B. Cumulative tax impact for AmLaw 100 therefore is $8.5B. Since there were 6,692 equity partners in this group, the average personal tax liability would be $373,580.
- Revenue for AmLaw 101-200 firms in 2012 was $18.5B. So the total phantom income impact is $4.6B, and the total tax impact at 40% = $1.85B. Cumulative tax impact for AmLaw 200 therefore is $10.35B. In this group of 9,647 equity partners, average personal tax liability is $191,769.
- It’s hard to get revenue numbers for the NLJ 350, but if you make some plausible assumptions about the way the AmLaw 200 revenue numbers decline by size of firm, it’s reasonable to assume that reveue of firms 201—350 is around $15B, for phantom income of $3.75B and tax @ 40% of $1.5B
Bottom line impact for the largest 350 law firms in the US: A one-time unfunded tax liability of $11.85-billion.
Since on or about September 15, 2008, every managing partner, executive committee member, and Executive Director/CFO/COO that I know has been pulling every available lever and string to cut expenses, right down to the Keurig coffee machines and yes, you know who you are. We have been struggling mightily to nip here and tuck there, and now we find a freight train bearing down us.
Finally, to maintain continuity of invoking Biblical phraseology between this installment and the first, the analogy here might be to the admonition against looking at the mote that is in your brother’s eye, while ignoring the log in your own.
We can and have dealt with the motes; it’s high time to snap to as an industry and do all we can to fend off this Congressional log.
If you don’t feel an ample sense of urgency yet, just wait for Part III.
*Speaking of “all affected” professional service firms, word seems to slowly be starting to spread. according to the online journal AccountingWeb, other groups who have chimed in in opposition to the proposal include not just the ABA and the AICPA, but also, in a jointly signed January 17 letter, the American Council of Engineering Companies, American Dental Association, American Institute of Architects, American Farm Bureau Federation, and the S Corporation Association.