Law Firm Accounting: Opening the Books
12.10.2015 | The American Lawyer
The criminal fraud trial of three former executives of Dewey & LeBoeuf this year cast a spotlight on an arcane, often tedious but essential part of the operations of any big law firm: accounting practices.
After hours and hours of testimony, jurors and observers alike were left in a fog of confusion about all the adjustments that the failed firm made to boost the income shown on its books. Jurors deadlocked on the most serious charges, while observers wondered if these financial maneuvers were legal, let alone appropriate.
The truth is that law firm accounting can be slippery, with gray areas that don’t exist for most other big businesses. U.S. law firms benefit from an exception in the tax law that lets them use a different, more advantageous, method of accounting than the standard method used by nearly every other big business. One of the benefits is that law firms can make adjustments that other businesses can’t without running afoul of accounting rules.
Most big businesses must prepare their financial statements and their income tax returns following the accrual method of accounting. Under that method, a business is taxed when it records a sale for a product or service, regardless of when it gets paid. If a business records a sale for $1 million of goods this November, but doesn’t get paid until February, that $1 million must still be included in the business’s income this year. Because the accrual method is considered a better reflection of income, the Internal Revenue Code requires that businesses with annual sales of more than $5 million use accrual accounting.
But the tax code allows an exception for law firms and other professional service partnerships, which can use the cash method. (A small number of big firms choose to use the accrual method, according to accountants who work for law firms.) Under the cash method, income isn’t taxed until the payment comes in the door, which means cash accounting allows taxpayers to delay reporting income. In the example above, the business would wait until next year to report this $1 million as income.
While some of the professional service partnerships that get this benefit are smaller practices of doctors, architects, engineers and even farmers, the biggest businesses that benefit from this exception are law firms of all sizes. “This is really the only major industry that is cash,” says Jeff Grossman, senior director of banking for Wells Fargo Private Bank’s legal specialty group. “It’s probably the largest industry that does this.” Rowan Williams, the head of the professional services group at RSM U.K. Tax and Accounting Limited, says that the U.S. is the only major country that gives law firms this special treatment.
One big reason that law firms prefer cash accounting is the tax benefit that it gives the partners. (Partnerships aren’t taxed on their income; the partners pay the tax.) Firms defer about four months of income taxation each year by using the cash method of accounting, according to James Cotterman, a principal and certified public accountant with consulting firm Altman Weil Inc. Firms also prefer cash accounting because it can be simpler and less expensive to administer than the accrual system.
If law firms used a pure cash accounting system, their financial statements would be relatively straightforward. Payments for services would be counted as income in the year they’re received, and expenses would be deducted in the year they’re paid. But for decades most law firms and other partnerships have used a slightly more complicated system called modified cash accounting.
Modified cash accounting lets firms continue to defer income, while using some of the deductions available to accrual taxpayers. But compared to accrual accounting-which must conform with professionally set accounting standards, such as Generally Accepted Accounting Principles (GAAP), which are set by the Financial Accounting Standards Board-the modified cash method has more flexibility. Conventions and accepted practices have developed over time for the modified cash method, including guidance from accounting authorities, but it’s a less formal system than GAAP. “There’s no specific set of rules [for modified cash accounting]. There are no set standards to go to,” says John Fitzgerald, chairman of the law firm services group at the accounting firm Berdon LLP. Still, he says, law firms shouldn’t be too creative. “Modifications should follow some logical rules,” he says. “For example, a firm couldn’t record accounts receivable but not accounts payable.”
Unlike public companies, law firms don’t necessarily have to prepare financial statements. But they do have to prepare tax returns, and firms that have borrowed money from banks or have lines of credit often have to prepare financial statements for their bankers, and perhaps for their landlords. And they also give financial information to their partners.
(Dewey was an anomaly in one key respect. It took the highly unusual step of raising $150 million through a private bond offering to investors, and the firm’s financial statements for that offering had to comply with rules set by the U.S. Securities and Exchange Commission. The SEC has sued five former Dewey executives, charging them with manufacturing fake revenue and inflating the firm’s profitability through accounting fraud.)
While firms have some leeway in how they prepare their financial statements, these documents should explain their accounting methods. “If you’re on modified cash, disclosure becomes critical,” says Fitzgerald.
But some firms go beyond what many accountants would recommend, believing that modified cash accounting gives them this license. “The accounting rules for law firms are squishy,” says law firm consultant Edwin Reeser, who was a managing partner of the Los Angeles office of Sonnenschein. In his role as a consultant, he was retained to examine the books of several firms after they went under, including Howrey and Heller Ehrman. He says that the majority of firms are conservative in their accounting, but the flexibility of modified cash accounting lets some push the edge. “There’s nothing inherently wrong with modified cash,” he says. “The problem is when you have a lack of discipline and possibly questionable motives, and start making adjustments that violate fundamental principles.”
For instance, firms can make income look higher by deducting certain expenses over a number of years, instead of subtracting the charges all at once in the year they’re paid. A firm might do this to show a higher profit on paper in the year the expense is paid, in order to satisfy a bank covenant or hand out more money to partners if it wants.
If a firm spent $5 million on a computer system, for example, it might take an expense of $1 million a year for five years. That, in turn, increases income in 2015 by $4 million on paper. The drawback is that this expense is a recurring drain on income for four more years. And if the firm distributes this $4 million to partners for 2015, it will have to borrow money or dip into capital to make up the difference between the income it shows in its books and what it has on hand.
The depreciation of some expenses, such as information technology, isn’t unusual. But the amortization of other expenses, such as payments connected to lateral partner hires, will raise some accountants’ eyebrows. Reeser says he’s seen firms amortize the first 90 days of payments to lateral partners, and spread those costs over three to five years to boost current income. If a firm brings in a dozen or more partners a year, this can have a significant impact on a firm’s financial statement, he says. He also says he knows of firms that amortize headhunter fees for lateral partners, instead of deducting them in the year they’re paid. These expenses are generally not amortizable under accrual accounting, according to Berdon’s Fitzgerald.
One law firm CFO confirms that he also knows of firms that have amortized payments to lateral partners. He’s also heard of firms that have extended depreciation periods to raise current income. This CFO says he knows of a firm that bought office furniture, which is usually depreciated over seven years under the accrual method, and spread the expense over 20 years. He’s also seen a firm amortize the costs of financing an affiliate, like a consulting practice. “The absence of rules for modified cash accounting allows law firms to be creative like this,” he says. “It’s totally up to them [how they make adjustments], because it’s undefined.”
Some firms believe that modified cash accounting allows them to manage their revenue by “holding open the books” to include payments received in early January in the prior year’s income. (Partners would pay tax on this additional income for the prior year.) Witnesses in the Dewey trial described how the firm did this, and said that partners were instructed to ask clients to backdate checks to the prior year. Defense lawyers suggested at trial that this accounting was proper because this money had been “constructively received” the previous year. Dewey apparently wasn’t the only firm that did this. “Everyone has seen firms that hold the books open,” says Fitzgerald about his fellow accountants. LeBoeuf, Lamb & MacRae, before it merged with Dewey, held its books open, according to Dewey trial testimony from Dianne Cascino, who was the revenue support director at Dewey and previously worked at LeBoeuf. Still, Fitzgerald says, this isn’t a proper practice, even under modified cash accounting. “It would be misleading,” he explains.
Some law firm leaders fear that one day their firms might be forced to move to accrual accounting. For decades, going back to at least the mid-1980s, Congress has toyed with the idea of requiring large law firms and other partnerships to use accrual accounting, citing the rationale of tax equality. Last year the leaders of the House Ways and Means Committee and the Senate Finance Committee introduced tax reform bills that would have raised an estimated $23.6 billion over 10 years by moving huge amounts of partnership income forward. (The additional tax could be paid over four years.) Those bills, which contained other tax revisions, died without coming to a vote.
“The notion of shifting taxpayers from cash to accrual is generally viewed as good tax policy,” says Steven Rosenthal, a senior fellow at the Urban-Brookings Tax Policy Center, who was previously a tax partner at Ropes & Gray. “The accrual method generally is viewed as more accurate. It’s a more clear reflection of income.” He adds: “The fact that [Congress] looked to lawyers and accountants to contribute a little more doesn’t strike me as inequitable. … It’s quite remarkable all the money they make.”
The American Bar Association doesn’t see it that way. In a letter last April to Senate Finance Committee chairman Orrin Hatch, ABA president William Hubbard stated that his group “unequivocally” opposed this idea, and cited a litany of problems it would create. It would make law firm accounting too complex, he wrote, and create substantial hardships for firms by taxing them on income they haven’t yet received and may never receive, forcing some to borrow money or tap their capital. (Income that’s taxed and never received, however, can be written off as a bad debt.)
In addition, Hubbard wrote, law firms would have to keep more detailed work and billing records and hire additional accountants and support staff to comply with GAAP, and would have to pay more to undergo a full audit. He also warned that accrual accounting would interfere with the lawyer-client relationship, because firms would be pressured to collect their fees much sooner.
A group of 18 law firms from The Am Law 200 wrote to Hatch, too. The letter, which was also signed by the American Institute of Architects and other professional groups, argued that this provision was simply an unjustified grab for more revenue.
Mary Burke Baker of K&L Gates, who helped draft this letter, says that at the moment there’s no pending legislation to force law firms into accrual accounting, but the threat remains. “We have no reason to believe the proposal has died,” she says. “It’s still viewed as a real risk to law firms.” When Rep. Paul Ryan (R-Wisconsin) was chairman of the House Ways and Means Committee, he had been working on tax reform legislation using the earlier tax reform bill as a starting point, she notes. It’s not clear what will happen with Ryan becoming speaker of the House. “The idea of instituting a policy that could push law firms into debt or further debt doesn’t seem to make a lot of sense,” she says.
Some believe that law firms should move to accrual accounting because it’s a sounder business practice. “It gives a fairer presentation of the financial statement,” says Altman Weil’s Cotterman.
Across the pond
The notion that law firms would be devastated by a move to accrual accounting is contradicted by the experience of firms in the United Kingdom. Firms there cried foul when British tax authorities announced in late 1997 that law firms would have to use accrual accounting, in the interest of the more equitable tax treatment of all businesses. Firms complained that their tax bills would rise, that they’d be forced to install costly, centralized time-keeping systems, and that they’d have to pay more for full-scale audits. Struggling firms, they warned, would collapse under these added costs.
“This is an unfair, punitive measure,” said Philip Sycamore, who was then the president of Britain’s Law Society, which is comparable to the American Bar Association in the U.S. “We are extremely concerned.”
George Bull, a principal at RSM U.K. Tax and Accounting Limited, who was a tax partner at the U.K. law firm Winckworth Sherwood at the time, recalls the opposition in the legal community. “It caused howls of outrage. It really was a very disturbing time,” he recalls. “But that was then. The U.K. legal profession is bigger and stronger than ever now. One can weather the storms.”
In fact, Bull says, U.K. firms are better off for switching to an accrual system, which forced them to adopt better business practices. “There’s a huge amount of discipline to ensure that partners bill on a prompt and timely basis,” he says. “The U.K. system puts pressure on partners to get bills out the door.” British firms have an added incentive to collect on work performed as quickly as possible, so that partners aren’t taxed on so-called phantom income they haven’t yet received.
Bull notes that unlike most big U.S. firms, U.K. firms push for collections each month, instead of delaying until a frenzy at year’s end. “Getting close to half your revenue near the end of the year is really quite ridiculous,” he notes about the practice of U.S. firms. “It’s bad for the client’s cash flow and bad for the firm’s cash flow.”
“I would bet my last dollar that every U.S. firm would be more diligent about collections if they were on accrual accounting,” said the chairman of a large U.S. firm, who still opposes such a change because of the tax consequences.
Tony Williams, a former managing partner of Clifford Chance who is now principal with Jomati Consulting in London, points out another benefit to accrual accounting: It allows for less manipulation. “In both systems there is room for some gaming and realignment of expenses,” he says. “But with accrual it’s harder to game the system.”