For the last several weeks I have focused on some of the nuances of collections and more specifically collections in law firms. Being on the road for the past several weeks has brought on the homesick bug and therefore, I thought this week’s contribution should be back to the basics; of accounting.
I can almost guarantee that if I were to ask a randomly selected group of people how much they embrace their tax system, their answer would be far from endearing, such words as detest and hate would fill the response. Why has taxation gotten such a bad rap? It was probably because of that famous slogan of the mid 1700’s; “no taxation without representation”. Whatever the reason, taxation is a good thing and it is good for many reasons. First, it means you have earned enough to not only survive but enough to repatriate, it keeps accountants employed and in Europe it stimulates collections! Why should anything that bears such benefit, be black listed? To gain a real appreciation for the importance of taxation on collections we need to have an appreciation of accounting, and then look at what European and other countries are doing.
The 1494 writings of Luca Pacioli had a greatest impact on the financial world. It was his writing, Particularis de Computis et Scripturis, a treatise on accounting that made Pacioli the Father of Modern Accounting. Pacioli established the basis of double entry bookkeeping and many of the structures of modern day financial record keeping. Today, accounting is one of the most vital organs in the commerce. Historians argue about what seeded the need for accounting, some argue that accounting was developed purely in response to the needs of the time brought about by changes in the environment and societal demands. Others claim that the development of the science of accounting has itself driven the evolution of commerce. It was only through the use of more precise accounting methods that modern business was able to grow, flourish and respond to the needs of its owners and the public. Either way, the history of accounting throws a light on economic and business history, and may help us better predict what is on the horizon as the pace of global business evolution escalates. Regardless of its origin, it is the basis of every tax system and it is here to stay!
For almost all US based law firms, cash-basis accounting is the mainstay. It is the way accounts have been managed since the first firm began, and the practice continues today. It is the very basis of maintaining the firm’s accounts on a cash-basis that creates the ‘year-end crunch’. This, however, isn’t the case in the rest of the world. In almost every country, professional services must run on the accrual basis. Accrual accounting redefines law firm revenue and profitability.
Cash accounting only recognizes revenue when cash is actually deposited, while accrual accounting recognizes revenue at the time of bill creation. What a motivator! Just that simple change of when to recognize revenue triggers a whole host of tax implications. Hence the motivation to collect! Who would want to pay tax on money they didn’t collect?
In December 1997, European Countries withdrew the practice of cash-basis accounting for computing taxable profits for professional services organizations in favor of a ‘true and fair’ approach’; accrual accounting basis. With the ‘go-live’ date in 1998, there was considerable upheaval in the legal community. Here were a group of professionals who had to radically change how they managed their organizations. They had to cast away the shackles of the mad year-end crunch for a more consistent approach of receivable management. Otherwise, they faced the penalty of the tax-man! Amongst the hostilities, there were many hidden benefits that today’s US law firms don’t see. European and other law firms around the world, have considerably lower average days to collect, better utilization of assets, better cash flow management and comparatively smaller operating lines of credit.
Let’s now fast forward and really make collections the forefront! On March 10, 2005, the Accounting Standards Board (UK) issued UITF Abstract 40. This circular plowed full force into uncharted territory in the professional services arena; revenue recognition and valuation of work in progress. Although a mainstay of manufacturing organizations, this was very new for professional services, and as such met with tremendous resistance. To the professional services firm… now revenue will be recognized when the work is done!
Once the accounting community worked out all the pieces; sure as anything the tax department jumped on the band wagon! With all the hoops and loops to be dealt with, the European tax authorities put in a plan for firms to take all of the work in progress into income; over time. Otherwise, firms with three months billings in WIP would recognize 125% uptake in revenue – straight to the bottom line! The end result of all of this… the inception of new accounting rules lead to progressive tax rules, which ultimately benefited the firm, bill faster and collect faster!
If it wasn’t for progressive accounting and taxation, would firms ever bill or collect?
Hooray for Taxation !!!